## Selected Economic Indicators and Policy Assessment (_cr12190)

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### The focus of the consultation
- Global economy struggling amid renewed financial strains; UK recovery sluggish relative to underutilized resources.
- Key questions addressed:
  - What explains the sluggish recovery?
  - How should macroeconomic policies be adapted to provide additional demand support?
  - How can financial sector policies reduce vulnerabilities, support a balanced recovery, and limit negative spillovers?
  - How should policies respond in case of negative shocks?

### Growth, output gap, and labor market
- Recent growth dynamics and levels:
  - Growth turned negative in Q4 2010, recovered to 0.7 percent in 2011, then declined by 0.3 percent in Q1 2012.
  - Output per capita is 14 percent below its pre-crisis trend and 6 percent below its pre-crisis level.
- Output gap estimates:
  - Staff estimate: about -4 percent in 2012, persisting into 2013 (based on two filter models, a production function model, and Okun’s Law).
  - OBR official estimate: output gap of -2.7 percent of GDP in 2012.
- Labor market and productivity:
  - Unemployment: 8.2 percent; youth unemployment: 21.9 percent.
  - Labor productivity well below pre-crisis trend; interpretations include "supply pessimists", "supply optimists", and "statistics skeptics".
- Hysteresis and potential output:
  - IMF staff use a hysteresis coefficient of around 0.1 in projections (see Annex on hysteresis: each 1 percentage point cumulative output gap → 0.1 percent fall in potential output via unemployment channel).
  - Annex upper-bound estimate: about 0.2 percent decline in potential output per 1 percentage point cumulative output gap.

### Demand composition, private sector repair, and investment
- Fiscal adjustment and domestic demand:
  - Consolidation of cumulative 4¾ percent of potential GDP in FY10/11 and FY11/12 estimated to have subtracted roughly 2½ percentage points from growth during these two years.
  - Total domestic demand growth turned negative on average since 2010.
- Private consumption and households:
  - Real private consumption: declined at a 1 percent annual rate over the last 18 months (from the report baseline).
  - Household saving rate: about 7½ percent.
  - Debt-to-income ratios fell from pre-crisis peaks but remain high.
  - Real household income declined by 1.2 percent in 2011.
- Private investment:
  - Real private fixed investment grew at an average annual rate of 3 percent over the last 18 months.
  - Investment had collapsed 24 percent during 2008-09; remains insufficient to offset other contractions.
- Housing:
  - House price-to-income ratio roughly 30 percent above historical average.
  - Staff projects house prices to decline relative to income by roughly 10-15 percent over the medium term.

### Financial sector conditions, bank health, and credit
- Credit and monetary conditions:
  - Broad money (M4) and real credit growth to the nonfinancial private sector: negative for the last two years.
  - Bank lending rates have fallen much less than the policy rate due to higher risk premia.
  - Bank funding costs and 5-year CDS spreads for some major UK banks rose near record highs, exceeding Lehman-crisis peaks for those banks.
  - SMEs (accounting for more than 50 percent of private-sector employment) particularly constrained.
- Bank health (Box 1 key points):
  - Core tier one capital ratios of major UK banks: over 10 percent; analyst estimates suggest UK banks still about 25 percent below fully-loaded Basel III requirements (not including countercyclical buffer top ups).
  - System-wide NPL ratio: essentially unchanged in 2011 at 4 percent.
  - Impairments remain substantial for some banks and segments, especially non-UK exposures.
  - Profitability declined slightly in 2011; two government-supported banks reported losses.
  - FSA review (June 2011): about one third of commercial real estate loans and 5-8 percent of residential mortgages subject to some form of forbearance.
- Factors constraining future credit expansion:
  - About two-thirds of the increase in capital ratios since 2008 reflects direct capital measures, majority government capital injections.
  - Balance sheet repair focused on legacy assets; further restructuring will be harder as "low-hanging fruit" plucked.
  - Contraction in derivatives positions and intra-financial lending reduced interconnectedness but limits further reduction since intra-financial activity provides funding.

### External sector, exchange rate, and external-adjustment assessment
- Net exports:
  - Net exports account for essentially all growth since 2010 and have contributed more than in the previous two recoveries.
- Exchange rates and competitiveness:
  - Sterling declined about 25 percent in CPI-based real effective terms at onset of crisis; subsequent appreciation modest.
  - ULC-based real effective exchange rate depreciation more muted due to weak productivity growth.
- External position estimates:
  - Cyclically-adjusted current account estimated about 1-2 percent of GDP below equilibrium.
  - Sterling estimated to be overvalued by 5-10 percent.
  - Moving to a more sustainable fiscal position expected to increase cyclically-adjusted current account by 1-2 percent of GDP (from -2 percent in 2011 to around -½ percent in steady state).
  - UK net IIP: -13 percent of GDP at end-2011; cyclically-adjusted current account of roughly -½ percent of GDP needed to stabilize IIP.
- Risks to assessment:
  - Downside: unwinding of labor hoarding could boost productivity and allow adjustment without real depreciation.
  - Upside: equilibrium IIP could be higher, implying larger overvaluation; mitigating factor: UK external assets have larger foreign-currency component relative to liabilities, making sterling depreciation an automatic stabilizer.

### Quarterly outlook, medium-term projections, and inflation
- Short-run outlook (2012):
  - Quarterly growth described as "choppy in 2012"; staff and consensus expect underlying growth to accelerate to "roughly a 1½ percent annual rate over the next 12 months" under eased euro-area tensions and avoided US fiscal cliff.
- Medium-term central scenario:
  - Growth accelerates to "only around 2½ percent in the medium term" under unchanged monetary stance and current fiscal plans.
  - Output gap projected to remain large and not close until 2018.
  - Hysteresis assumed to lower potential GDP growth by "about a third of a percentage point annually on average over the medium term" plus another fifth of a percentage point from other lingering crisis effects; absent these, potential growth about 2¼ percent.
- Inflation and wages:
  - Headline inflation: peaked at 5.2 percent in late 2011; reached 2.8 percent in May 2012.
  - Staff expects inflation to fall to around 1.7 percent by end-2013 (modestly below target).
  - Core inflation currently close to 2 percent.
  - Nominal wage growth: 2 percent.

### Risks (selected from Risk Assessment Matrix)
- Strong intensification of euro area crisis:
  - Relative likelihood: Medium; Impact: High.
  - Policy response: Monetary policy support; longer-term liquidity for banking sector; ease pace of fiscal consolidation; promote bank capital replenishment via strict limits on dividends and remuneration.
- Significant deterioration of banks’ asset quality:
  - Relative likelihood: Medium; Impact: Medium.
  - Policy response: Use financial buffers counter-cyclically; limit dividends and remuneration; require equity issuance; if necessary, inject public capital (only for solvent banks); enhance liquidity provision; ease macro policies.
- Oil price hike:
  - Relative likelihood: Low; Impact: Medium.
  - Sensitivity: "Each 10 percent increase in crude prices is estimated to temporarily reduce growth by 0.15 percentage points and raise inflation by 0.2 percentage points"; oil price shocks estimated to have reduced growth by "½ percentage point in 2011".
- Extended housing market slump:
  - Relative likelihood: High; Impact: Medium.
  - Policy response: Ease monetary conditions further; revisit pace of fiscal consolidation.
- Stagflation due to smaller-than-estimated output gap:
  - Relative likelihood: Low; Impact: High.
  - Policy response: Strengthen efforts to increase potential growth; tighten macro policies if needed.

### Monetary policy and credit easing: tools, estimated effects, and proposals
- Monetary easing history and scale:
  - Bank Rate cut to 0.5 percent.
  - QE1 purchases: £200 billion (March 2009–January 2010).
  - QE2 additions (Oct 2011 and Feb 2012) bring total stock to £325 billion (21 percent of GDP), almost entirely government bonds.
- Estimated QE effects:
  - QE1 reduced yields by 50-100 basis points.
  - BoE estimates QE1 boosted GDP by 1½-2 percent (equivalent to a policy rate cut of 150-300 basis points).
  - QE2 had muted market reactions; composition surprises in Feb 2012 produced relative-yield effects comparable to QE1.
- Policy rate cut considerations:
  - Rule-of-thumb: 25 basis points cut could boost growth by 0.1-0.2 percentage points, equivalent to fiscal stimulus of 0.2-0.4 percent of GDP.
  - Flattened yield curve may make rate cut more powerful; yields flat at policy rate out to 4-year maturities.
  - About 90 percent of lending linked to 5-year-or-below range; 60 percent of lending at variable rates.
  - Costs to weigh include effects on money markets and bank margins.
- Credit easing proposals:
  - National Loan Guarantee Scheme: provides £20 billion in guarantees over two years; intended to save participating banks 1 percentage point on funding costs, passed on to reduce SME loan rates on identical amount by 1 percentage point.
  - Staff-recommended measures:
    - Longer-term bank funding facilities (2-3 years) against a wide range of collateral, including SME loans (with haircuts), with regulatory complements to avoid dependency.
    - Purchases of private-sector assets (e.g., covered bonds) on non-discretionary rules to ease mortgage market conditions and support residential investment and house prices.
  - Government authorized BoE to purchase up to £10 billion of private-sector assets; only £350 million used to date.
- Recent measures (June 2012):
  - Funding for Lending program: intended to provide banks multi-year funding at below-market rates, linked to banks’ lending performance (details pending as of June 2012).
  - ECTR: BoE offers at least £5 billion of 6-month sterling liquidity monthly until further notice; first auction June 20 provided £5 billion at policy rate plus 25 basis points.

### Fiscal policy: consolidation, multipliers, and alternative scenarios
- Consolidation to date:
  - Overall deficit peaked at 11 percent of GDP in FY09/10.
  - Coalition frontloaded 5-year consolidation; deficit fell to 8¼ percent of GDP in FY11/12.
  - Structural adjustment over last 2 years: about 4¾ percent of GDP.
  - Staff assumes average fiscal multiplier during consolidation ≈ 0.5, implying consolidation reduced GDP by cumulative 2½ percent so far.
- Fiscal adjustment pace:
  - Fiscal adjustment slowed from "3 percentage points in FY10/11" to "2 percentage points in FY11/12" and expected to ease to "½ percentage points in FY12/13".
- Public finance table highlights (selected staff projections and Budget figures):
  - Real GDP growth (staff projections): -2.4, 2.2, 0.2, 0.6, 1.5, 2.4, 2.6, 2.6 (selected years).
  - Output gap (staff projections): -2.2, -1.9, -3.3, -4.0, -3.9, -3.0, -2.1, -1.6 (selected years).
  - Net debt (Budget vs staff): e.g., Budget: 52.6, 60.5, 67.3, 71.9, 75.0, 76.3, 76.0, 74.3; Staff: 52.6, 60.5, 66.6, 71.9, 76.4, 78.8, 79.7, 79.0 (selected years).
  - General government gross debt (Maastricht basis): Budget series and staff projections show increase to mid-90s percent of GDP by mid-decade.
- Budget-neutral reallocations to support growth (examples and suggested reforms):
  - Cuts in low-multiplier spending to fund higher-multiplier infrastructure.
  - Cuts to top income tax rate from "50 to 45 percent" and corporate tax reduction by "1 percentage point, to 22 percent by FY14/15".
  - Property tax reform to shift base from transactions to current property values in a net revenue-generating manner.
  - Revenue-neutral allowance for new corporate equity to reduce bias toward debt.
- If recovery remains stalled — contingent response:
  - Slow consolidation, especially planned structural adjustment for FY13/14 (planned to accelerate from "½ percent of GDP in FY12/13" to "nearly 1½ percent of GDP in FY13/14").
  - Fiscal easing to focus on infrastructure spending and temporary targeted tax cuts (e.g., to lower-income households).
  - Any scaling back of consolidation should be in the context of a multi-year plan and accompanied by deeper entitlement reform (e.g., accelerated increases in state pension age) to preserve credibility.

### Annex 3 simulations on delaying consolidation (key scenarios and outcomes)
- Alternative fiscal scenario design:
  - Near-term stimulus: CAPB deteriorates by 1 percent of GDP in FY12/13 and maintained in FY13/14 → cumulative fiscal stimulus ≈ 4¼ percent of GDP over two years relative to baseline.
  - Medium-term: consolidation phased in starting FY14/15 to restore debt/deficit to baseline by 2025.
  - Hysteresis parameter: 0.1 (each 1 percent output gap reduces potential GDP by 0.1 percent annually).
  - Output-gap persistence: 0.5 (gap closes by half each year absent shocks).
- Results:
  - Symmetric multipliers (Alternative 1; multiplier constant at 0.8): no benefit to delaying consolidation.
  - Asymmetric multipliers by output gap (Alternative 2): delayed consolidation can yield cumulative discounted GDP gains of 0.25 percent over 2011-25 (multipliers rise from 0.15 at +3% gap to 1.2 at -4% gap).
  - Growth-sensitive multipliers (Alternative 3): delaying consolidation can produce negative outcomes (loss of -0.25 percent cumulative discounted GDP) because delayed consolidation makes medium-term adjustment steeper, raising multipliers during consolidation and amplifying adverse effects.
- Nonmodeled risks and costs:
  - Higher debt/deficits could raise risk premia, crowd out capital accumulation, reduce buffers, and create political economy risks that delays are not delivered.

### Financial sector policy, regulation, and supervision
- Objectives:
  - Balance financial stability and cyclical support while promoting credit to the economy.
  - Emphasize building capital buffers rather than contracting lending.
- Regulatory institutional changes:
  - Financial Services Bill to create:
    - Statutory Financial Policy Committee (FPC) for macroprudential policy.
    - Prudential Regulation Authority (PRA), subsidiary of BoE, for prudential regulation.
    - Financial Conduct Authority (FCA) for conduct and consumer protection.
  - Implementation concerns: clarity of FCA prudential mandate, availability of high-quality resources for PRA and FCA, and authority of PRA over holding companies.
- Macroprudential toolkit and supervisory priorities:
  - Interim FPC requested powers to adjust countercyclical capital buffer, sectoral capital requirements, and leverage ratio.
  - FPC considered, but deferred, time-varying liquidity tool pending international standards.
  - Additional powers desirable to limit loan-to-value and loan-to-income ratios to address property bubbles.
  - Intensified supervision and broader authority over financial holding companies recommended.
- FSAP Update (Annex 4) implementation status (selected):
  - PRA/FCA transition underway; resource constraints and need for recruitment noted.
  - Proactive Intervention Framework (PIF) to be established for firm oversight; implementation will take time.
  - Plans to strengthen disclosure, data requirements, and contingency planning for CCPs; BoE to become sole overseer of payment and settlement activities.
- Spillovers and G-SIB contagion (Annex 5):
  - Two UK G-SIBs identified as having "great capacity to generate spillovers" and high susceptibility during market stress.
  - Funding-shock scenario: deleveraging could exceed 10 percent of GDP in France, Germany, the UK, and emerging Europe.
  - Policy implication: UK financial stability is a global public good; highest quality supervision required.

### Authorities' response and concurrence
- Authorities broadly concurred with staff’s overall assessment; OBR projects wide output gap though somewhat smaller than staff’s central scenario.
- Monetary and credit easing:
  - Majority of MPC did not see further easing warranted at that time given headline inflation above target and disinflation uncertainty; decision finely balanced.
  - Authorities examining use of government balance sheet credibility for targeted credit support (e.g., guarantees).
  - BoE (Governor) announced development of a program to tackle high funding costs directly.
- Fiscal policy stance:
  - Authorities emphasized progress in strengthening public finances; slower near-term consolidation viewed as allowing automatic stabilizers to operate.
  - Authorities caution discretionary fiscal loosening could undermine credibility and be punished by markets.
- Financial sector policies:
  - Interim FPC recommendations broadly supported (use of liquidity buffers, review of liquidity guidelines, capital buildup without curtailing lending).
  - Authorities agreed on need for adequate supervisory resources and to consider greater authority over financial holding companies.

### Staff appraisal — concise recommendations
- Additional macro easing needed given ample spare capacity and weak demand:
  - Monetary policy: further QE and reassessment of policy rate cut efficacy given flattened yield curve.
  - Credit easing: support for Funding for Lending and consideration of purchases of private-sector assets; ensure regulatory measures to avoid bank dependency.
  - Fiscal policy: deeper budget-neutral reallocations toward infrastructure and high-multiplier spending; allow automatic stabilizers to operate; scale back consolidation if growth remains weak despite monetary and credit easing, within a multi-year credible framework and accompanied by entitlement reform.
- Financial stability:
  - Continue strengthening bank balance sheets by building capital (raise external capital; limit dividends/bonuses).
  - Evaluate liquidity requirements with cyclical considerations and BoE liquidity insurance.
  - Grant broader macroprudential powers to FPC, including limits on loan-to-value and loan-to-income ratios.
  - Intensify supervision and grant adequate authority and resources to PRA/FCA; address "too big to fail" through resolution frameworks and living wills.

### Key macroeconomic indicators (selected, 2008–13)
- Real GDP: -1.1 (2008), -4.4 (2009), 2.1 (2010), 0.7 (2011), 0.2 (2012), 1.4 (2013, proj.)
- Domestic demand: -1.8 (2008), -5.4 (2009), 2.9 (2010), -0.8 (2011), -0.1 (2012), 0.6 (2013, proj.)
- CPI, end period: 3.1 (2008), 2.9 (2009), 3.7 (2010), 4.7 (2011), 2.0 (2012), 1.7 (2013, proj.)
- Unemployment rate (ILO): 5.6 (2008), 7.5 (2009), 7.9 (2010), 8.0 (2011), 8.3 (2012), 8.3 (2013, proj.)
- General government gross debt: 56.5 (2008), 71.1 (2009), 76.5 (2010), 84.4 (2011), 89.8 (2012), 93.9 (2013, proj.)
- Public sector net debt: 43.5 (2008), 52.6 (2009), 60.5 (2010), 66.6 (2011), 71.9 (2012), 76.4 (2013, proj.)
- M4 (12-month percent change, end-period): 15.5 (2008), 6.7 (2009), -1.5 (2010), -2.5 (2011), -3.8 (2012)
- Bilateral exchange rate (June 13, 2012): US$1 = £0.6417

*Italic: Source — UNITED KINGDOM: 2012 ARTICLE IV REPORT (content unit _cr12190).*

### 1.             Selected             Economic             Indicators,             2008-13

### _cr12190 - 1.             Selected             Economic             Indicators,             2008-13

### The focus of the consultation
- The global economy is struggling to regain its footing amid renewed financial strains.
- The UK’s economic recovery has been sluggish relative to the scale of underutilized resources.
- Key questions addressed:
  - What explains the sluggish recovery?
  - How should current macroeconomic policies be adapted to provide additional demand support?
  - How can financial sector policies reduce vulnerabilities, support a balanced recovery, and limit negative spillovers to the rest of the world?
  - How should policies respond in case of negative shocks?

### Recovery has stalled — Causes and context
- Large pre-crisis imbalances produced headwinds for growth:
  - Growth before the crisis was brisk, led by consumption and fueled by declining national saving and rising leverage.
  - The household share of national income fell sharply; households reduced saving and borrowed more to sustain consumption and a housing bubble.
  - Public finances entered the crisis with little policy space and deteriorated sharply when the crisis hit; much of the deterioration was structural, reflecting permanent revenue losses and a sharp drop in potential GDP growth during the crisis.
- Sustainable recovery requires addressing leverage and debt and rebalancing demand toward private sector-led demand (greater investment and net exports).
- Financial sector repair and reform are needed to support growth and prevent another buildup of imbalances; progress has been mixed.

### Growth has stagnated and the output gap remains large
- Recent growth dynamics:
  - Growth turned negative in the last quarter of 2010, recovered to 0.7 percent in 2011, then declined by 0.3 percent in the first quarter of 2012.
  - Output per capita is 14 percent below its pre-crisis trend and 6 percent below its pre-crisis level.
- Labor market and productivity:
  - Unemployment is 8.2 percent; youth unemployment is 21.9 percent.
  - Labor markets have been relatively resilient with fewer employment losses than in previous major UK recessions, leaving labor productivity well below its pre-crisis trend.
- Interpretations of the productivity shortfall (three views):
  - “Supply pessimists”: the drop in productivity is mainly permanent, implying a small output gap; cite elevated inflation (exceeding 5 percent in late 2011), restrained unemployment increases, and limited spare capacity reported by businesses.
  - “Supply optimists”: a large permanent technology reversal is implausible; high inflation can be explained by transitory shocks; restrained unemployment and low productivity reflect labor hoarding and imply a large output gap that could close with more demand.
  - “Statistics skeptics”: official statistics may underestimate growth; revisions could shrink the gap but are unlikely to explain most of it.
- Staff estimate:
  - Using a broad range of indicators (two filter models, a production function model, and a model based on Okun’s Law), staff finds a large output gap of about -4 percent in 2012, which persists at this level into 2013.
  - The Office for Budget Responsibility (OBR) official estimate: output gap of -2.7 percent of GDP in 2012, relying mostly on limited spare capacity reported by businesses.

### Internal rebalancing has not fully materialized
- One-sided and inadequate rebalancing of domestic demand:
  - Large and frontloaded fiscal adjustment has been an important headwind.
  - Consolidation amounting to a cumulative 4¾ percent of potential GDP in FY10/11 and FY11/12 is estimated to have subtracted roughly 2½ percentage points from growth during these two years.
  - Underlying private domestic demand has been insufficiently strong to offset the fiscal drag; total domestic demand growth has turned negative on average since 2010.

### Private consumption and household balance-sheet repair
- Real private consumption:
  - Declined at a 1 percent annual rate over the last 18 months.
- Household balance-sheet dynamics:
  - Fall in house prices during the crisis and more subdued expectations for house price appreciation have contributed to a sharp increase in the household saving rate to about 7½ percent.
  - Households are reducing indebtedness; debt-to-income ratios have fallen from pre-crisis peaks but remain high historically and cross-country.
  - Household net worth has been bolstered by the recovery of asset prices, but gross debt has fallen only a bit.
  - Effective interest rates on outstanding stock of household debt by type of loan show some cash flow relief for indebted households as interest rates came down during the crisis.

*Italic: Source — 2012 ARTICLE IV REPORT UNITED KINGDOM (excerpts from Selected Economic Indicators, 2008-13)*

### 11.      In addition, private consumption has been held back by weak household incomes and

### _cr12190 - 11.      In addition, private consumption has been held back by weak household incomes and

### Private consumption
- Real household income declined by 1.2 percent in 2011.
- Contributing factors:
  - Higher global commodity prices.
  - A 2½ percentage point VAT increase drove up inflation and reduced households’ spending power.
  - Growth in nominal wages remained low amid high unemployment.
  - Consumer confidence fell to levels not seen since the Lehman crisis due to high commodity prices, concerns about job prospects, and heightened turmoil in the euro zone.

### Private investment
- Real private fixed investment grew at an average annual rate of 3 percent over the last 18 months.
- Investment remains insufficient to:
  - Recover from its 24 percent collapse during 2008-09.
  - Offset contraction of other elements of domestic demand during the recovery.
- Industrial survey respondents cite uncertainty about future demand as the overarching factor restraining investment.
- Escalation of euro area turmoil in the latter half of 2011 led to a reduction in investment intentions by firms.

### Financial sector conditions and effects on private demand
- Despite an accommodative monetary policy stance, credit conditions remain tight due to an incomplete process of financial repair and high risk premia exacerbated by euro area stress.
- Bank lending rates have fallen much less than the policy rate due to higher risk premia.
  - Observed average lending rate overstates the true drop because the composition of lending has shifted toward lower-risk credit (e.g., higher credit scores required for mortgages).
- Bank funding costs have risen over the last two years with escalating euro area tensions:
  - 5-year CDS spreads for some major UK banks are now near record highs and exceed their Lehman-crisis peaks.
  - Higher funding costs have squeezed net interest margins and reduced banks’ incentive to lend.
- Broad money (M4) and real credit growth to the nonfinancial private sector have been negative for the last two years.
- SMEs, which account for more than 50 percent of private-sector employment, have been particularly constrained.
- Bank of England credit surveys confirm credit availability and lending conditions remain much tighter than pre-crisis levels.
- Demand-side factors have also contributed to weak credit growth:
  - Banks report a considerable decline in the demand for loans.
  - Household loan demand started to recover in early 2009 but has fallen again since 2010.
  - Corporate loan demand contraction may reflect substitution toward debt markets; capital markets have provided alternative funding for larger companies, with bond issuance more than offsetting the decline in lending over the last two years.

### Factors that may constrain future credit expansion
- Capital-raising efforts:
  - About two-thirds of the increase in capital ratios since 2008 reflects direct capital measures, with the majority being government capital injections.
  - Reliance on asset-shedding and risk weight optimization has increased.
- Post-crisis restructuring:
  - Balance sheet repair has focused on legacy assets and restoring a sound banking sector; future restructuring targets will be more difficult as the low-hanging fruit has been plucked.
- Reduction of intra-financial assets:
  - Most contraction in UK banks’ balance sheets since 2008 concentrated on derivatives positions and intra-financial system lending, reducing interconnectedness and fragility.
  - Scope for further reduction is limited because intra-financial activity also provides funding and supports the real economy.

### Box 1 — The Health of UK Banks (key points)
- Market stress:
  - Stress in UK banks’ funding and equity markets intensified in the second half of 2011 as euro area stress intensified.
  - UK bank equity prices fell, and CDS spreads for some major UK banks rose sharply above their previous Lehman-crisis peaks, though CDS spreads remained below those of many core euro area banks.
  - Interbank funding and US$ basis swap spreads widened, though significantly less than in the euro area.
- Policy spillovers:
  - Funding conditions improved following special policy measures (ECB LTROs and Fed expansion of US$ swap facilities); these policies had positive spillovers to UK banks.
  - Renewed euro area turmoil in May-June prompted CDS spreads to spike back near record levels; BoE announcements in mid-June eased spreads somewhat, but they remain high.
- Capital and liquidity:
  - Capital ratios broadly flat; pace of capital-raising slowed sharply over the last two years.
  - Core tier one capital ratios of major UK banks, at over 10 percent, are above-average in Europe but lower than US and Asian peers.
  - Analyst estimates suggest UK banks are still about 25 percent below the capital levels required under fully-loaded Basel III (not including countercyclical buffer top ups).
  - EBA stress tests and capital adequacy exercise did not identify capital shortfalls for UK-owned banks; direct sovereign exposures limited but private sector and indirect exposures more substantial.
  - Liquidity and funding profiles gradually improving: loan-to-deposit ratios continued to trend down as deposit bases expanded; reliance on market wholesale funding increased slightly as banks refinanced away from central bank and government facilities; disposal of non-core assets reduced the need for wholesale funding.
  - Funding needs this year appear manageable, with banks ahead of schedule in their funding plans.
- Asset quality and forbearance:
  - System-wide NPL ratio essentially unchanged in 2011 at 4 percent.
  - Impairments remain substantial for some banks and segments, especially non-UK exposures.
  - Rapid reductions in non-core assets imply credit losses should slow down.
  - An FSA review (June 2011) found about a third of commercial real estate loans and 5-8 percent of residential mortgages subject to some form of forbearance; such forbearance is more highly provisioned and unlikely to be of systemic importance but increases uncertainty about exact balance sheet conditions.
- Profitability:
  - System-wide profitability declined slightly in 2011; two government-supported banks reported losses.
  - Profitability affected by high impairments (mainly non-UK exposures), non-core disposal losses, one-off factors (e.g., charges for mis-sold payment protection insurance), and higher wholesale funding costs as strains in Europe intensified.

### Rebalancing toward external demand and external position
- Net exports have contributed much more to growth during this cycle than during the previous two recoveries and account for essentially all of the growth since 2010.
- Drivers of external adjustment:
  - Fiscal consolidation and private-sector deleveraging suppressed domestic demand growth below foreign demand growth.
  - Depreciation of sterling exchange rate:
    - Sterling declined by about 25 percent in real effective terms (CPI-based) at the onset of the crisis and has since appreciated only modestly.
    - Depreciation of the ULC-based real effective exchange rate has been more muted due to weak productivity growth.
- Staff assessment of external position:
  - The cyclically-adjusted current account balance is estimated to be about 1-2 percent of GDP below its equilibrium value.
  - Sterling is estimated to be overvalued by 5-10 percent.
  - Moving to a more sustainable fiscal position is expected to increase the cyclically-adjusted current account balance by 1-2 percent of GDP, from -2 percent of GDP in 2011 to around -½ percent of GDP in the steady state.
  - A cyclically-adjusted current account of roughly -½ percent of GDP is needed to stabilize the UK’s net international investment position (IIP), which was -13 percent of GDP at end-2011.
  - A macroeconomic scenario yielding current account adjustment to around -½ percent of GDP in the medium term is consistent with exchange rate depreciation of 5-10 percent.
  - Cross-country price-level comparisons suggest overvaluation of a similar magnitude.
- Risks to the assessment:
  - Downside risk that an unwinding of labor hoarding could boost productivity and competitiveness, allowing adjustment without as much real depreciation; this productivity burst is uncertain.
  - Upside risk that the degree of overvaluation is larger because the UK’s small net IIP masks gross liabilities over 600 percent of GDP; if the equilibrium IIP were higher, this would suggest more overvaluation.
  - Mitigating factor: the UK’s external assets have a larger foreign-currency component relative to its external liabilities, so sterling depreciation acts as a powerful “automatic stabilizer” of the IIP.

*International Monetary Fund — UNITED KINGDOM 2012 ARTICLE IV REPORT (excerpts from pages 13–21)*

### 18.       Quarterly growth will be choppy in 2012, as

### _cr12190 - 18.       Quarterly growth will be choppy in 2012, as

### Quarterly outlook and underlying growth
- Quarterly growth described as "choppy in 2012", with extra holidays depressing growth in Q2 and the Olympics boosting it in Q3.
- Staff and consensus forecasts expect underlying growth to accelerate to "roughly a 1½ percent annual rate over the next 12 months" under a scenario of eased euro area tensions and substantially avoided US fiscal cliff effects.
- With government expenditure contracting, the expected acceleration is projected to be driven by private demand.

### Private consumption
- Household real disposable income growth should improve as past consumption tax hikes and oil price shocks fade.
- The soft housing market and high household debt are likely to restrain consumption acceleration.
- House price-to-income ratio remains "roughly 30 percent above its historical average".
- Staff projects house prices to decline relative to income by "roughly 10-15 percent over the medium term", with adverse effects on consumption via wealth effects.

### Investment
- Investment is at historically low levels as a percent of GDP, leaving "much room for it to rebound" as global growth prospects improve and uncertainty falls with easing euro area turmoil.
- Recovery in investment should be supported by low interest rates and strong corporate cash positions.

### Net exports
- The euro area accounts for "roughly half" of UK trade; export growth in the first half of 2012 expected to be weak given the weak outlook for the region.
- Exports should strengthen toward the end of the year with a modest pick-up in growth in both the euro area and the US.
- Over the medium term, net exports are expected to continue contributing positively to growth, conditional on low real effective exchange rates and low relative demand for nontradables.
- A large output gap is projected to narrow only gradually, raising the risk of hysteresis.

### Medium-term projections and hysteresis
- Staff’s central scenario (unchanged monetary stance and current fiscal plans) projects growth to accelerate to "only around 2½ percent in the medium term".
- Under this scenario, the output gap is projected to remain large for an extended period and not close until 2018.
- Hysteresis effects are assumed to lower potential GDP growth by "about a third of a percentage point annually on average over the medium term", with other lingering crisis effects taking off "another fifth of a percentage point".
- Absent these effects, potential growth would be "about 2¼ percent".
- Staff notes the magnitude of hysteresis effects is uncertain but plausible given cross-country experience.

### Inflation and wages
- Inflation elevated since January 2010 due to indirect tax hikes and commodity price shocks; now falling.
- Headline inflation reached "2.8 percent in May 2012" after peaking at "5.2 percent in late 2011".
- Staff expects inflation to fall to "around 1.7 percent—modestly below the target—by end-2013".
- Core inflation is currently running close to "2 percent".
- Nominal wage growth is anemic at "2 percent".
- Market-based and survey inflation expectations remain broadly stable.

### Downside risks (highlights)
- Further setbacks to the euro area crisis: overarching risk given substantial trade and financial links; could trigger a self-reinforcing cycle of banking losses, funding cost increases, tighter credit, lower confidence and exports, and falling real estate prices.
- Larger-than-expected headwinds from public and private deleveraging or house prices falling more than expected, producing prolonged negative output gaps.
- Alternative risk: the output gap may be smaller than estimated, producing higher-than-expected inflation and lower-than-expected growth.

### Policy guidance and recommended responses
- Given ample spare capacity and weak demand, additional macroeconomic easing is recommended to close the output gap faster, reduce hysteresis risk, and insure against downside risks.
- Policy options carry risks and uncertainty about effectiveness but must be weighed against the risk of persistent weak growth and high unemployment.
- A "more supportive macroeconomic policy stance is essential"; specific policy options are discussed in subsequent sections (monetary and credit easing policies).

### Risk Assessment Matrix (selected entries)
- Strong intensification of euro area crisis
  - Relative likelihood: Medium
  - Impact if realized: High
  - Policy response: Use monetary policy supportively; provide longer-term liquidity for the banking sector; ease the pace of fiscal consolidation; promote bank capital replenishment through strict limits on dividends and remuneration.
- Significant deterioration of banks’ asset quality
  - Relative likelihood: Medium
  - Impact if realized: Medium
  - Policy response: Examine scope for using financial buffers counter-cyclically; strictly limit dividends and remuneration; require more equity issuance; if necessary, inject public capital (only for solvent banks); enhance liquidity provision; ease macro policies further.
- Oil price hike
  - Relative likelihood: Low
  - Impact if realized: Medium
  - Policy response: Maintain easy monetary conditions to deal with GDP impact.
  - Notable numeric sensitivity: "Each 10 percent increase in crude prices is estimated to temporarily reduce growth by 0.15 percentage points and raise inflation by 0.2 percentage points"; oil price shocks are estimated to have reduced growth by "½ percentage point in 2011".
- Extended housing market slump
  - Relative likelihood: High
  - Impact if realized: Medium
  - Policy response: Ease monetary conditions further; revisit the pace of fiscal consolidation.
- Stagflation due to smaller-than-estimated output gap
  - Relative likelihood: Low
  - Impact if realized: High
  - Policy response: Strengthen efforts to increase potential growth (labor force and productivity); tighten macro policies to re-anchor inflation expectations and address structural fiscal deficits if needed.

### Financial sector exposures and external claims (summary points)
- Major UK banks’ direct exposures to vulnerable euro-area sovereigns are shown as percentages of core Tier 1 capital, with exposures concentrated in Greece, Portugal, Italy, Spain, and Ireland.
- Total external claims of consolidated UK-owned MFIs trended down in late 2011, driven by reductions in claims on the private sector while claims on the public sector continued to increase.
- There has been a shift away from cross-border claims toward local claims over the last four years.
- The United States remains the most important borrower country, followed by France and Germany.
- UK-owned banks have gradually reduced exposures to euro area countries facing elevated sovereign yields both in absolute amounts and relative to the overall external portfolio.

*Source: IMF staff calculations.*

### 26.      Following the onset of the crisis, the BoE cut its key policy rate (the Bank Rate paid on

### _cr12190 - 26.      Following the onset of the crisis, the BoE cut its key policy rate (the Bank Rate paid on

### Monetary policy response and context
- The Bank of England (BoE) cut the Bank Rate (paid on central bank reserves) to a historic low of 0.5 percent.
- Initial asset purchases (QE1) amounted to £200 billion conducted between March 2009 and January 2010.
- Purchase announcements of October 2011 and February 2012 (QE2) bring the total stock of purchased assets to £325 billion (21 percent of GDP). These purchased assets consist almost entirely of government bonds.
- Despite monetary easing, monetary and credit conditions remain tight due to elevated risk aversion and rising bank funding costs.

### Rationale for further monetary stimulus
- Anemic wage growth and well-contained inflation expectations provide scope for further monetary stimulus to close the output gap faster and avoid inflation undershooting in the medium term.
- Risks: uncertainty about inflation dynamics and the strength of disinflationary pressure from the output gap imply inflation could take longer-than-expected to return to target; additional monetary stimulus could further delay convergence.
- Benefit assessment: the cost of delayed convergence is likely low relative to benefits of more rapidly closing the large output gap and reducing unemployment.
- Monetary easing aligns with the MPC’s mandate “to set interest rates so that inflation can be brought back to target within a reasonable time period without creating undue instability in the economy.”
- Monetary stimulus will assist balance sheet repair; a low interest rate-growth rate differential is the only way to simultaneously achieve rapid household and corporate deleveraging and renewed borrowing to fund consumption and investment.

### Plain-vanilla QE: estimated effects and considerations
- Estimates suggest QE1 reduced yields by 50-100 basis points.
- The BoE estimates QE1 boosted GDP by 1½-2 percent, an impact equivalent to a policy rate cut of 150-300 basis points.
- QE2: relatively muted market reactions to announcements raised concerns QE may be becoming less effective; however, market anticipation complicates assessment.
- BoE research indicates large surprises in the composition of QE purchases across maturities in February 2012 produced changes in relative yields across maturities comparable to QE1 effects.
- QE is likely to stimulate lending by increasing deposits in the banking system as the nonbank sector sells bonds to the BoE and deposits the proceeds in the banking system.
- Such an expansion of the deposit base should support lending by making it easier for banks to reduce loan-to-deposit ratios and move to Basel III liquidity requirements without scaling back loans.

### Consideration of a policy rate cut
- Rules-of-thumb suggest cutting the policy rate by 25 basis points could boost growth by 0.1-0.2 percentage points—perhaps equivalent to fiscal stimulus of 0.2-0.4 percent of GDP.
- The substantial flattening of the yield curve near the policy rate over the last 18 months may have made a rate cut more powerful than usual.
- With yields roughly flat at the policy rate out to 4-year maturities, a rate cut may reduce yields nearly one-for-one much further out into the curve than usual.
- About 90 percent of lending to the private sector is linked to the 5-year-or-below range; 60 percent of lending is at variable rates—effects on yields of 5 years or below are therefore especially important.
- Flattening yield curve has reduced the scope for QE to compress term premia further.
- Costs to weigh:
  - MPC concern that a rate cut may reduce activity in money markets. Counterpoint: policy rates of ¼ percent or less prevail in the US and Japan without producing adverse side effects sufficient to prod a policy reversal.
  - MPC concern that some financial institutions may have difficulties cutting deposit rates enough to offset lower interest on mortgages tied to the policy rate, potentially reducing financial sector profits and affecting financial stability.
  - Counter-evidence: average sight and time deposit rates of 0.21 percent and 1.34 percent, respectively, would seem to provide scope to lower deposit rates in response to a policy rate cut.
  - Banks could increase charges for services; complementary credit easing measures would further support interest margins.

### Credit easing and bank funding policy proposals
- Rationale: government borrowing costs have fallen to record-low levels while private-sector credit conditions remain tight; credit easing can lower risk premia and more directly reduce private-sector borrowing costs.
- Spring 2012 National Loan Guarantee Scheme: provides £20 billion in government guarantees on wholesale bank funding over two years; the cost of the guarantee is set to save each participating bank 1 percentage point on funding costs, which banks must pass along by reducing interest rates on an identical amount of SME loans by 1 percentage point.
  - Concern: gross SME lending by participating banks significantly exceeds the size of the scheme; scheme may mainly lower interest rates on loans that would have occurred anyway, limiting impact on marginal borrowers.
- May mission concluding statement recommended two types of credit easing:
  - Longer-term bank funding facilities: BoE liquidity facilities currently provide term funding of a year or less; propose 2-3 year funding against a wide range of collateral, including SME loans (with appropriate haircuts), to trim funding costs and boost demand for eligible collateral. Such facilities would need regulatory complements to avoid dependency and ensure bank restructuring and buffer building.
  - Purchases of private-sector assets to ease credit conditions and boost demand: e.g., purchases of covered bonds to ease mortgage market conditions, spur covered bond issuance, support residential investment and house prices, and thereby support consumption via wealth effects. Because the objective is broad easing, purchases should be based on nondiscretionary rules (e.g., allocation by market share or behaviors with positive externalities). Government authorization and indemnification of the BoE from losses may be required, as the BoE views assumption of credit risk as a government decision.
- Government authorization: the government has authorized the BoE to purchase up to £10 billion of private-sector assets, of which it has used only £350 million.

### Recent and announced measures (June 2012)
- Funding for Lending program: designed by the BoE in consultation with the Treasury to provide funding to banks for an extended period of several years (against collateral, with appropriate haircuts) at below current market rates and linked to each bank’s performance in sustaining or expanding lending to the UK nonfinancial sector. Details were to be announced in the coming weeks (from June 2012).
- Extended Collateral Term Repo Facility (ECTR) activation: announced in December 2011 and activated; BoE will offer, via competitive auction, at least £5 billion of 6-month sterling liquidity, at least once a month until further notice.
  - Borrowing can be backed by a wide range of collateral (the same set eligible in the discount window), including portfolios of household and SME loans.
  - ECTR uses a uniform price format; successful bidders pay the lowest accepted clearing rate, subject to a minimum of 25 basis points over the policy rate.
  - The first ECTR auction on June 20 provided banks with £5bn in sterling liquidity, at a fee of the policy rate plus 25 basis points.
- Assessment: these measures are welcome and could ease credit conditions and boost demand, but further details on the funding for lending program are needed to evaluate fully. It is unclear to what degree banks will access these facilities; effects of these measures are not included in staff’s central scenario at this point.
- Depending on details and performance, additional measures such as purchases of private-sector assets on secondary markets may be needed. Implementation may require “learning-by-doing” and adjustments based on results.

### Box 3 — Credit easing: key considerations (summary)
- Credit easing: central bank or government purchases of private-sector assets with credit or equity risk to lower risk premia (spreads of private-sector borrowing rates over government borrowing rate) and stimulate demand.
- Motivations for credit easing in the UK:
  - Shrinking scope to cut risk-free rates further: 10-year yield is now 1.6 percent; risk premia have risen substantially and now constitute the largest part of most private-sector borrowing rates.
  - Policy diversification: QE’s stimulative effect magnitude is uncertain; diversification may add value.
- Concern: credit easing exposes the government to credit risk, which could be costly. Such operations should be profit-making in expectation, but may entail net expected costs in risk-adjusted terms if markets price risks correctly and government buys at a discount.
- Potential justifications for expected profitability:
  - Markets may be mispricing risk due to excessive risk aversion; raising demand for risky assets could be non-costly in expectation.
  - Multiple equilibria: government action could move the economy from a low-demand equilibrium to a higher-demand equilibrium, potentially making credit easing profitable in expectation even when markets price risk for the low-demand scenario.
- Risk comparison: undertaking credit risk is not necessarily less risky than QE. QE raises public sector exposure to interest rate risk by shortening consolidated public sector debt maturity; the covariance of credit risk and interest rate risk matters. The BoE’s balance sheet is currently exposed to significantly less credit risk than the Federal Reserve or European Central Bank.

### Using the government’s balance sheet and infrastructure
- Government is considering expanding government guarantees (for a fee) to fund large, privately operated infrastructure projects.
- Boosting infrastructure spending would support growth given its high multiplier and ability to increase productive capacity.
- Emphasis: choice of projects, modalities (public vs. private operation), and financing (issuing public debt vs. guarantees) should be based on efficient use of public funds.
- Decisions should not be affected by artificial attempts to limit government gross debt or near-term expenditure by transforming costs into contingent liabilities that might be realized only later.

### Fiscal policy: consolidation to date
- Pre-crisis loose fiscal policy, damage to potential GDP, and crisis stimulus raised the overall deficit to 11 percent of GDP in FY09/10.
- The coalition government in mid-2010 committed to two fiscal mandates:
  - i) balance the structural current budget by the end of a rolling 5-year window; and
  - ii) put the net debt-to-GDP ratio on a downward path in FY15/16.
- Government announced a frontloaded 5-year consolidation plan aiming to meet both mandates a year early.
- Deficit fell to 8¼ percent of GDP in FY11/12 (which ended on April 5, 2012).
- Structural adjustment over the last 2 years has equaled about 4¾ percent of GDP.
- Staff assumes an average fiscal multiplier during consolidation of about 0.5 after incorporating boosts from automatic stabilizers and the monetary policy reaction; this implies consolidation has so far reduced GDP by a cumulative 2½ percent.
- The pace of consolidation slows in 2012, considered appropriate given the weak outlook.

*International Monetary Fund — UNITED KINGDOM: 2012 ARTICLE IV REPORT*

### 40.      Fiscal adjustment—as measured by the change

### Fiscal adjustment—as measured by the change in the ratio of the cyclically-adjusted primary balance (CAPB) as a percent of potential GDP

### Fiscal adjustment and fiscal outcomes
- Fiscal adjustment slowed from "3 percentage points in FY10/11" to "2 percentage points in FY11/12".
- It is expected to ease further to only "½ percentage points in FY12/13" under current fiscal plans.
- The slowdown partly reflects the authorities’ November 2011 decision not to undertake additional discretionary tightening over the next 3 years in response to the OBR’s upward revisions to the structural deficit, owing to substantial downward revisions to potential GDP and near-term potential growth.
- The government chose to:
  - use up all previous buffers, such that both mandates are now met just in time and with little margin; and
  - announce further, unspecified consolidation in 2015-17.
- Under staff’s weaker medium-term growth projections, the net debt target is expected to be met one year late.
- If future OBR revisions to projected growth produce a similar result, such a delay should be accommodated rather than prevent the operation of automatic stabilizers.

### Public sector operations (selected table figures as presented)
2012 Budget (Percent of GDP, unless otherwise noted)
- Primary balance: -9.2, -6.5, -5.3, -5.0, -3.3, -1.5, 0.0, 1.7
- Overall balance: -11.1, -9.3, -8.3, -7.6, -5.9, -4.3, -2.8, -1.1
- Cyclically adjusted current balance: -5.5, -4.4, -4.6, -4.2, -2.7, -1.5, -0.7, 0.5
- Cyclically adjusted primary balance (CAPB) 2/ (In percent of potential GDP): -6.7, -4.1, -3.3, -3.0, -1.6, -0.1, 1.0, 2.1
- Fiscal adjustment (change in CAPB) 2/: ..., 2.6, 0.8, 0.3, 1.5, 1.5, 1.1, 1.1
- Net debt: 52.6, 60.5, 67.3, 71.9, 75.0, 76.3, 76.0, 74.3
- General government gross debt 3/ (On a Maastricht treaty basis): 71.1, 76.5, 84.0, 89.0, 91.9, 92.7, 91.4, 88.6

Memorandum items (2012 Budget)
- Real GDP growth (percent): -2.4, 2.2, 0.5, 1.0, 2.3, 2.8, 3.1, 3.0
- Potential GDP growth (percent): ..., 1.0, 0.2, 1.1, 2.0, 2.3, 2.3, 2.3
- Output gap (percent): -4.1, -2.9, -2.6, -2.7, -2.4, -1.9, -1.1, -0.4

Staff projections (selected table figures)
- Primary balance: -9.2, -6.5, -5.2, -5.4, -4.0, -2.4, -0.8, 0.7
- Overall balance: -11.1, -9.3, -8.2, -8.0, -6.7, -5.4, -3.8, -2.3
- Cyclically adjusted current balance: -6.6, -5.3, -4.4, -3.8, -2.5, -1.7, -0.9, -0.1
- Cyclically adjusted primary balance (CAPB) 2/: -7.9, -5.0, -3.1, -2.6, -1.2, -0.1, 0.8, 1.9
- Fiscal adjustment (change in CAPB) 2/: ..., 2.9, 1.9, 0.5, 1.4, 1.1, 0.9, 1.1
- Net debt: 52.6, 60.5, 66.6, 71.9, 76.4, 78.8, 79.7, 79.0
- General government gross debt 3/: 71.1, 76.5, 84.4, 89.8, 93.9, 95.9, 96.1, 94.9

Memorandum items (staff projections)
- Real GDP growth (percent): -2.4, 2.2, 0.2, 0.6, 1.5, 2.4, 2.6, 2.6
- Potential GDP growth (percent): 0.1, 1.9, 1.6, 1.4, 1.4, 1.5, 1.7, 2.0
- Output gap (percent): -2.2, -1.9, -3.3, -4.0, -3.9, -3.0, -2.1, -1.6

Sources noted in table: UK Treasury; and staff projections.
- Footnotes included in the source:
  - 2/ In percent of potential GDP.
  - 3/ On a Maastricht treaty basis. Includes temporary effects of financial sector interventions.
  - 1/ Fiscal year starts April 6. Excludes temporary effects of financial sector interventions, unless otherwise noted, as well as the one-off effect on public sector net investment in 2012/13 of transferring assets from the Royal Mail Pension Plan to the public sector.

### Budget-neutral reallocations to support growth
- Measures adopted over the last year to support demand:
  - Spending cuts in items with low multipliers (e.g., public employee wages) to fund increased spending on items with high multipliers (e.g., infrastructure spending).
  - Cuts to top income tax rate (from "50 to 45 percent") and corporate tax rate (by "1 percentage point, to 22 percent by FY14/15").
  - Higher taxes on sales of expensive homes and rationalization of income tax allowances.
- Scale of these adjustments has been modest—the fiscal effect of each individual measure is "0.1 percent of GDP or less".
- Suggested deeper, budget-neutral reallocations and reforms:
  - Property tax reform aimed at shifting more of the base from transactions to current property values, in a net revenue-generating manner.
  - Further restraining growth of public employee compensation, focusing on positions where public-private sector pay premia are the largest.
  - Better targeting of transfers to those most in need.
  - Use fiscal space to increase infrastructure spending.
  - Revenue-neutral tax reform to introduce an allowance for new corporate equity to reduce bias in favor of debt over equity finance and encourage deleveraging through equity accumulation.

### If the recovery remains stalled: scaling and composition of consolidation
- Further slowing of consolidation would likely entail reneging on the net debt mandate. Evidence suggests little chance of major market turmoil from moderate increases in debt-to-GDP for advanced economies with monetary independence.
- Bond yields have been driven more by growth expectations than fears of a sovereign crisis; absence of market response to the easing of structural adjustment in the 2011 Autumn Statement supports this.
- Alternative fiscal simulations (Annex 3):
  - Symmetric multipliers across the cycle:
    - Path of fiscal consolidation has essentially no effect on cumulative GDP; delaying consolidation trades higher growth today for lower growth tomorrow.
  - Asymmetric multipliers across the cycle:
    - Substantial GDP gains possible if asymmetry is relatively large.
- Empirical uncertainty:
  - The Spring 2012 Fiscal Monitor finds a weak relationship between the output gap and multipliers in the UK.
  - Other studies find stronger evidence for asymmetry; Auerbach and Gorodnichenko (2012) suggest multipliers may correlate better with growth rates than the level of the output gap.
- Recommended contingent policy response if growth remains weak despite monetary and credit easing:
  - Further slow fiscal consolidation, particularly scaling back planned structural adjustment for FY13/14 (planned to accelerate from "½ percent of GDP in FY12/13" to "nearly 1½ percent of GDP in FY13/14").
  - Fiscal easing measures should focus on higher infrastructure spending and temporary targeted tax cuts (e.g., to lower-income households).
  - Slower fiscal tightening should be accompanied by deeper entitlement reform, including legislating accelerated increases in the state pension age to help safeguard confidence in fiscal sustainability.

### Financial sector policies — strengthening bank balance sheets and regulatory framework
- Objective: balance financial stability and cyclical considerations while supporting credit to the economy.
- Capital and liquidity:
  - Rebuilding of banks’ capital and liquidity buffers has been valuable.
  - Focus should be on building capital rather than contracting lending.
  - Interim FPC and FSA should encourage banks to raise external capital “as early as feasible” and link dividend and remuneration approval to credible stress tests.
  - Interim FPC should clarify expectations about the transition path to Basel III capital ratios to avoid accelerated deleveraging with adverse cyclical implications.
- Liquidity regime:
  - Since 2010, UK liquidity requirements have been more stringent than in other jurisdictions and perhaps in excess of Basel III requirements.
  - This strengthened liquidity and funding positions but may have constrained credit availability.
  - Interim FPC should evaluate liquidity requirements with a view to converge to the international phase-in schedule while considering cyclical factors and the availability of liquidity insurance from the BoE.
  - Banks should improve funding profiles by expanding deposit bases and lengthening wholesale funding terms.
  - BoE should stand ready to provide liquidity through a range of facilities if euro area strains intensify; banks’ prepositioning of collateral facilitates access.

### Strengthening the framework for financial sector stability
- Financial Services Bill (expected early 2013) will:
  - Create statutory FPC responsible for macroprudential policy.
  - Create Prudential Regulation Authority (PRA), a subsidiary of the BoE, responsible for prudential regulation of banks, insurance companies, and large investment firms.
  - Create Financial Conduct Authority (FCA) responsible for conduct and regulation of secondary markets, investment funds, small investment firms, and consumer protection.
- Implementation and resources:
  - Progress made on 2011 IMF FSAP Update recommendations, but many initiatives tied to the transition; need assessment when work is finalized.
  - Concern remains about clarity of the prudential mandate of the FCA and availability of high-quality resources for PRA and FCA.
  - Greater authority of the PRA over financial holding companies is essential for effective supervision.
- Macroprudential toolkit:
  - Interim FPC has requested directive powers to adjust the countercyclical capital buffer, sectoral capital requirements, and the leverage ratio.
  - FPC considered a time-varying liquidity tool but deferred pending international standards.
  - Additional powers desirable to limit loan-to-value and loan-to-income ratios to address property bubbles; higher capital requirements alone may be insufficient.
  - Macroprudential tools should be complemented by intensified supervision.
- International coordination and too-big-to-fail:
  - Spillover analysis highlights potential for large shocks to be transmitted through the UK financial system (Annex 5).
  - Cross-border supervisory cooperation and timely exchange of key information are priorities.
  - EU-wide financial legislation (e.g., CRDIV) is under development; compromise draft provides greater national flexibility but falls short of Basel III minima in some areas.
  - Progress on resolution frameworks and recovery and resolution plans for major institutions is welcome.
  - Government White Paper response to the Independent Commission on Banking:
    - Permits simple derivative products to be provided directly to third parties from within the ringfence (more permissive than ICB proposal).
    - Adopts a leverage ratio of "3 percent" for all banks in line with Basel III proposals, instead of "4 percent" for large ringfenced banks as proposed by the ICB.
  - Recommendation: push at the European level to allow leverage ratio to increase above the Basel III minimum alongside weighted capital ratios; Financial Services Bill should grant FPC the power to tighten the leverage ratio as needed.
  - Caution: ringfencing and other measures should not create complacency about accumulation of risks outside the ringfence.

*Source: UNITED KINGDOM — 2012 ARTICLE IV REPORT, INTERNATIONAL MONETARY FUND*

### 57.      The authorities broadly concurred with staff’s overall assessment of economic developments.

### _cr12190 - 57.      The authorities broadly concurred with staff’s overall assessment of economic developments.

### Authorities' assessment and general stance
- The authorities broadly concurred with staff’s overall assessment of economic developments.
- Like staff, the OBR projects the output gap to remain wide for the coming years, though they project the size and duration of this deviation to be somewhat less than in staff’s central scenario (Table 3; paragraph 21).
- The authorities highlighted the complexity of assessing the true state of the economy and degree of slack, noting:
  - labor market indicators are somewhat better than growth outcomes;
  - inflation has declined more slowly than expected.
- They noted significant uncertainty regarding the degree of hysteresis effects, citing little evidence so far of a rise in the NAIRU.
- They remained focused on pursuing policies that can support growth while maintaining fiscal and monetary stability.
- They agreed that all policy options come with risks, including uncertainty concerning their effectiveness, and that there could be some merit in policy diversification.

### Monetary and Credit Easing Policies
- With headline inflation still above the target and ongoing uncertainty about the disinflationary power of the output gap, the majority of the MPC did not yet see further easing as warranted at this time; this decision was finely balanced for many MPC members.
- If the balance tilts toward easing, there was agreement that quantitative easing can continue to support demand by lowering long-term interest rates and improving banks’ liquidity position.
- Several MPC members noted the flattening yield curve might make a cut in the policy rate more stimulative than otherwise, but cautioned this might be outweighed by possible adverse effects on:
  - the availability of bank credit (as a result of a squeeze in banks’ and building societies’ margins);
  - the functioning of money markets.
- On credit easing, the authorities are examining further ways to use the credibility of the government’s balance sheet to ease credit conditions and support the economy, notably through the use of guarantees.
- Authorities noted staff’s suggestion to complement standard QE with purchases of private-sector assets (possibly with the BoE acting as the government’s agent) or provision of longer-term bank funding (against collateral) to more directly reduce private-sector borrowing costs, but highlighted that all policies must be delivered within European Commission State Aid constraints.
- They noted scope to purchase private-sector bonds is somewhat constrained by the moderate size of these markets in the UK (excluding unsecured bank bonds).
- The BoE underscored that it would not embark on large-scale purchases of private-sector assets on its own accord because it views the assumption of credit risk as a decision to be made by the government.
- After the May Article IV mission and as discussed earlier (paragraph 34), the Governor of the BoE announced that a program is being developed to tackle high funding costs directly and improve credit conditions.

### Fiscal Policy
- Authorities emphasized significant progress in strengthening public finances, with the cyclically-adjusted primary deficit cut in half since 2009.
- They stressed the slower pace of fiscal consolidation in FY12/13 was occurring as a result of the flexibility provided by the government’s fiscal framework, which allows automatic stabilizers to operate, rather than any discretionary fiscal action.
- They highlighted significant risks that discretionary changes to fiscal plans to slow the pace of tightening could undermine the implementation and credibility of their fiscal strategy and be punished by markets.
- They recognized time lags and logistical impediments of the policy options raised by staff.
- They view supporting UK financial stability—which has large global spillovers—as a significant constraint on the UK’s fiscal space, particularly considering tensions in the euro zone.
- If downside risks materialize, further monetary and credit easing were identified as the first ports of call for discretionary response, with the fiscal framework allowing for automatic stabilizers to operate freely while ensuring plans were set to restore public finances to a sustainable path.
- Authorities agreed budget-neutral reallocations can be used to provide demand stimulus and pointed to policies announced in the 2011 Autumn Statement.
- They are exploring options to use the credibility of the government’s balance sheet to provide targeted support to the economy, in particular for the provision of credit, housing, and infrastructure.

### Financial Sector Policies
- In seeking to balance financial stability and cyclical considerations, the Interim FPC has recommended that banks take the opportunity to raise capital levels by limiting distributions of dividends and bonuses while maintaining credit supply and are relatively dovish on liquidity requirements, consistent with staff’s position.
- The government is considering carefully the recommendations made by the Interim FPC and will consult on proposals as soon as possible regarding the FPC’s toolkit.
- The authorities agreed with the Fund recommendation that ensuring the adequacy of high-quality supervisory resources will be a key to success in the transition to the new institutional structure for the conduct of supervision.
- They agreed in principle to give consideration to whether greater authority over financial holding companies than currently envisaged in the draft Financial Services Bill is necessary, and stressed this matter needs to be tackled in the context of the emerging international crisis management framework.

### Staff appraisal — findings and policy recommendations
- Current policies aim to assist economic rebalancing. Substantial progress has been made toward achieving a more sustainable budgetary position and reducing fiscal risks. Bold monetary stimulus has helped support the economy.
- The macroeconomic policy mix assists in rebalancing the economy toward investment and net exports. In the financial sector, policies have encouraged the buildup of buffers, the oversight framework is being strengthened, and work is underway to enhance the capacity to deal with systemically important financial institutions.
- But the recovery has stalled, and unemployment is still too high. Activity is expected to gain modest momentum going forward, but additional macroeconomic easing is needed to close the output gap faster, reduce the risks of hysteresis, and insure against the predominance of downside risks.
- Monetary policy:
  - As a first step, further monetary stimulus is required.
  - Monetary stimulus can be provided via further QE and cutting the policy rate.
  - Evidence suggests QE can continue to support demand by lowering long-term interest rates and improving banks’ liquidity.
  - The MPC should reassess the efficacy of cutting the policy rate, taking into account the recent sharp flattening of the yield curve, as well as possible effects on money markets and financial stability.
- Credit easing:
  - Recently announced efforts to lower private-sector borrowing costs through broader provision of bank funding are welcome, as elevated funding costs have limited the quantity and tenor of lending to the private sector, while government borrowing costs have fallen to record lows.
  - Depending on the details and performance of these new programs, further credit easing measures may be needed, including purchases of private-sector assets on secondary markets.
  - Credit easing measures will need to be complemented by regulatory policies to ensure that banks do not become dependent on such facilities.
- Fiscal options:
  - Deeper budget-neutral reallocations could support recovery; such reallocations within the current overall fiscal stance could include greater investment spending funded by property tax reform or spending cuts on items with low multipliers.
  - Automatic stabilizers should continue to operate freely.
  - It will be important to shield the poorest from the impact of consolidation.
  - Scaling back fiscal tightening plans should be the main policy lever if growth does not build momentum by early-2013 even after further monetary stimulus and strong credit easing measures.
  - To preserve credibility, any adjustment to the path of consolidation should be in the context of a multi-year plan and ideally accompanied by deeper entitlement reform, such as legislating accelerated increases in the pension age.
  - Temporary easing measures in such a scenario should focus on infrastructure spending and targeted tax cuts, as they may be more credibly temporary.
- Financial stability and regulatory recommendations:
  - Continue efforts aimed at bolstering financial stability to anchor a strong and durable recovery and reduce the risk to taxpayers, as well as limit spillovers from shocks transmitted through the UK financial system.
  - Policies should promote continued strengthening of the financial sector by balancing stability and growth considerations.
  - Focus on strengthening bank balance sheets by building capital rather than reducing assets.
  - Supervisors should continue to encourage banks to focus on improving capital buffers by raising external capital and limiting the payout of bonuses and dividends.
  - Evaluation of liquidity requirements should take into account cyclical considerations and the availability of liquidity insurance from the BoE.
  - It is crucial that “too big to fail” issues are addressed. Progress in developing a more flexible resolution framework and “living wills” for major institutions is welcome.
  - Reforms proposed by the ICB should be legislated, resisting pressure to reduce their effectiveness.
  - A broader macroprudential toolkit for the FPC is desirable; in particular, the power to limit loan-to-value and loan-to-income ratios is essential, as higher capital requirements alone are likely to be insufficient to restrain property bubbles.
  - Intensifying supervision and broadening authority over financial holding companies is a priority. Adequacy of high-quality supervisory resources will be a key to the success of the transition to the new institutional structure for the conduct of supervision.
  - Greater authority over financial holding companies than currently envisaged in the draft Financial Services Bill will be essential for the future Prudential Regulatory Authority.
  - The emerging international crisis management framework provides an opportunity to revisit this issue. International collaboration will be necessary to further bolster the stability of the financial system, and the UK authorities should continue to exercise leadership in these matters.

*Source: _cr12190 - 57.      The authorities broadly concurred with staff’s overall assessment of economic developments.*

### 75.      It is recommended that the next Article IV consultation with the United Kingdom be held on

### _cr12190 - 75.      It is recommended that the next Article IV consultation with the United Kingdom be held on

### 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, 2008–13)
- Real GDP: -1.1 (2008), -4.4 (2009), 2.1 (2010), 0.7 (2011), 0.2 (2012), 1.4 (2013, proj.)
- Domestic demand: -1.8 (2008), -5.4 (2009), 2.9 (2010), -0.8 (2011), -0.1 (2012), 0.6 (2013, proj.)
- Private final domestic demand: -2.7 (2008), -5.9 (2009), 1.1 (2010), -0.8 (2011), 1.0 (2012), 1.2 (2013, proj.)
- CPI, end period: 3.1 (2008), 2.9 (2009), 3.7 (2010), 4.7 (2011), 2.0 (2012), 1.7 (2013, proj.)
- Unemployment rate (ILO): 5.6 (2008), 7.5 (2009), 7.9 (2010), 8.0 (2011), 8.3 (2012), 8.3 (2013, proj.)
- Gross national saving (percent of GDP): 15.6 (2008), 12.7 (2009), 12.1 (2010), 12.9 (2011), 11.6 (2012), 12.6 (2013, proj.)
- Gross domestic investment (percent of GDP): 17.0 (2008), 14.2 (2009), 15.4 (2010), 14.8 (2011), 14.2 (2012), 14.4 (2013, proj.)
- General government overall balance (percent of GDP): -6.9 (2008), -11.4 (2009), -9.4 (2010), -8.4 (2011), -8.1 (2012), -6.8 (2013, proj.)
- General government gross debt: 56.5 (2008), 71.1 (2009), 76.5 (2010), 84.4 (2011), 89.8 (2012), 93.9 (2013, proj.)
- Public sector net debt: 43.5 (2008), 52.6 (2009), 60.5 (2010), 66.6 (2011), 71.9 (2012), 76.4 (2013, proj.)
- M4 (12-month percent change, end-period): 15.5 (2008), 6.7 (2009), -1.5 (2010), -2.5 (2011), -3.8 (2012), ...
- Net lending to private sector (12-month percent change, end-period): 5.0 (2008), 0.5 (2009), -0.4 (2010), -0.2 (2011), -0.4 (2012), ...
- Three-month interbank rate (year average): 5.8 (2008), 1.2 (2009), 0.7 (2010), 0.9 (2011), 1.1 (2012), ...
- Ten-year government bond yield (year average): 4.7 (2008), 3.6 (2009), 3.6 (2010), 3.1 (2011), 2.2 (2012), ...
- Current account balance (percent of GDP): -1.4 (2008), -1.5 (2009), -3.3 (2010), -1.9 (2011), -2.6 (2012), -1.8 (2013, proj.)
- Trade balance (percent of GDP): -2.7 (2008), -1.8 (2009), -2.5 (2010), -1.8 (2011), -1.8 (2012), -0.9 (2013, proj.)
- Exports of goods and services (volume change): 1.3 (2008), -9.5 (2009), 7.4 (2010), 4.6 (2011), 1.6 (2012), 3.8 (2013, proj.)
- Imports of goods and services (volume change): -1.2 (2008), -12.2 (2009), 8.6 (2010), 1.2 (2011), 1.3 (2012), 1.3 (2013, proj.)
- Bilateral exchange rate (June 13, 2012): US$1 = £0.6417
- Holdings of currency (in percent of quota, as of May 31, 2012): 64.8
- Holdings of SDRs (in percent of allocation, as of May 31, 2012): 94.4
- Quota (in millions of SDRs): 10,738.5

### Medium-term scenario and projections (2007–17 highlights)
- Real GDP (annual): 3.5 (2007), -1.1 (2008), -4.4 (2009), 2.1 (2010), 0.7 (2011), 0.2 (2012), 1.4 (2013 proj.), 2.2 (2014 proj.), 2.6 (2015 proj.), 2.6 (2016 proj.), 2.7 (2017 proj.)
- Q4/Q4 real GDP: 1/4.1 (2007), -5.4 (2008), -0.8 (2009), 1.7 (2010), 0.5 (2011), 0.8 (2012), 1.2 (2013 proj.), 2.6 (2014 proj.), 2.7 (2015 proj.), 2.5 (2016 proj.), 2.8 (2017 proj.)
- Private consumption: 2.7 (2007), -1.5 (2008), -3.5 (2009), 1.2 (2010), -1.2 (2011), 0.4 (2012), 0.8 (2013 proj.), 1.9 (2014 proj.), 2.6 (2015 proj.), 2.6 (2016 proj.), 2.8 (2017 proj.)
- Fixed investment (total): 8.1 (2007), -4.8 (2008), -13.4 (2009), 3.1 (2010), -1.2 (2011), -0.2 (2012), 1.7 (2013 proj.), 4.7 (2014 proj.), 6.1 (2015 proj.), 6.0 (2016 proj.), 6.9 (2017 proj.)
- Current account (percent of GDP): -2.5 (2007), -1.4 (2008), -1.5 (2009), -3.3 (2010), -1.9 (2011), -2.6 (2012), -1.8 (2013 proj.), -1.5 (2014 proj.), -1.0 (2015 proj.), -0.8 (2016 proj.), -0.8 (2017 proj.)
- CPI inflation, end period: 2.1 (2007), 3.1 (2008), 2.9 (2009), 3.7 (2010), 4.7 (2011), 2.0 (2012), 1.7 (2013 proj.), 1.7 (2014 proj.), 1.8 (2015 proj.), 1.8 (2016 proj.), 1.9 (2017 proj.)
- Unemployment rate (period average): 5.4 (2007), 5.4 (2008), 5.6 (2009), 7.5 (2010), 7.9 (2011), 8.0 (2012), 8.3 (2013 proj.), 8.3 (2014 proj.), 8.2 (2015 proj.), 7.8 (2016 proj.), 7.4 (2017 proj.)

### Public finance, operations, and debt (selected fiscal year data and staff projections)
- General government revenue (percent of GDP): 36.4 (2009/10), 37.3 (2010/11), 37.5 (2011/12), 37.5 (2012/13), 37.7 (2013/14), 37.8 (2014/15), 37.6 (2015/16), 37.9 (2016/17)
- Taxes (percent of GDP): 34.4 (2009/10), 28.7 (2010/11), 29.1 (2011/12), 29.0 (2012/13), 29.1 (2013/14), 29.2 (2014/15), 28.9 (2015/16), 29.0 (2016/17)
- Expenditure (percent of GDP): 47.6 (2009/10), 46.5 (2010/11), 45.8 (2011/12), 45.1 (2012/13), 43.6 (2013/14), 42.2 (2014/15), 40.5 (2015/16), 39.0 (2016/17)
- Net lending/borrowing (overall balance, percent of GDP): -11.1 (2009/10), -9.3 (2010/11), -8.3 (2011/12), -7.6 (2012/13), -5.9 (2013/14), -4.3 (2014/15), -2.8 (2015/16), -1.1 (2016/17)
- Cyclically adjusted overall balance (staff estimates): -7.8 (2009/10), -10.1 (2010/11), -7.8 (2011/12), -6.2 (2012/13), -5.4 (2013/14), -3.9 (2014/15)
- General government gross debt (Maastricht basis, percent of GDP): 71.1 (2009/10), 76.5 (2010/11), 84.4 (2011/12), 89.8 (2012/13), 93.9 (2013/14), 95.9 (2014/15), 96.1 (2015/16), 94.9 (2016/17) (staff projections)
- Public sector net debt (percent of GDP): 52.6 (2009/10), 60.5 (2010/11), 66.6 (2011/12), 71.9 (2012/13), 76.4 (2013/14), 78.8 (2014/15), 79.7 (2015/16), 79.0 (2016/17) (staff projections)
- Output gap (percent of potential, memorandum): -4.1 (2009/10), -2.9 (2010/11), -2.6 (2011/12), -2.7 (2012/13), -2.4 (2013/14), -1.9 (2014/15), -1.1 (2015/16), -0.4 (2016/17)

### Balance of payments and external position (selected)
- Current account (percent of GDP, annual series): -2.6 (2005), -3.2 (2006), -2.5 (2007), -1.4 (2008), -1.5 (2009), -3.3 (2010), -1.9 (2011)
- Trade balance (percent of GDP, annual series): -3.4 (2005), -3.1 (2006), -3.0 (2007), -2.7 (2008), -1.8 (2009), -2.5 (2010), -1.8 (2011)
  - Trade in goods: exports 16.9 (2005), 18.3 (2006), 15.7 (2007), 17.6 (2008), 16.4 (2009), 18.2 (2010), 19.8 (2011)
  - Trade in goods: imports 22.3 (2005), 24.1 (2006), 22.1 (2007), 24.1 (2008), 22.3 (2009), 24.9 (2010), 26.5 (2011)
  - Trade in services: exports 9.5 (2005), 10.2 (2006), 10.9 (2007), 11.9 (2008), 12.0 (2009), 12.0 (2010), 12.5 (2011)
  - Trade in services: imports 7.5 (2005), 7.5 (2006), 7.5 (2007), 8.1 (2008), 7.9 (2009), 7.7 (2010), 7.7 (2011)
- Income balance: 1.7 (2005), 0.7 (2006), 1.5 (2007), 2.3 (2008), 1.5 (2009), 0.6 (2010), 1.4 (2011)
- Current transfers: -0.9 (2005), -0.9 (2006), -1.0 (2007), -1.0 (2008), -1.1 (2009), -1.4 (2010), -1.5 (2011)
- Capital and financial account (percent of GDP): 2.9 (2005), 2.6 (2006), 2.0 (2007), 2.0 (2008), 2.0 (2009), 3.1 (2010), 1.9 (2011)
  - Direct investment (percent of GDP): 4.3 (2005), 3.0 (2006), -4.5 (2007), -3.6 (2008), 1.2 (2009), 0.9 (2010), 1.0 (2011)
  - Portfolio investment (percent of GDP): -1.7 (2005), 1.0 (2006), 9.0 (2007), 22.6 (2008), 1.9 (2009), 0.1 (2010), 0.9 (2011)

### General government stock positions and net investment position (selected)
- Net financial worth (percent of GDP): -25.9 (2005), -26.7 (2006), -27.7 (2007), -32.3 (2008), -43.2 (2009), -52.9 (2010), -67.6 (2011)
- Financial assets (percent of GDP): 21.6 (2005), 20.9 (2006), 21.2 (2007), 26.8 (2008), 31.1 (2009), 31.0 (2010), 32.4 (2011)
- Liabilities (percent of GDP): 47.5 (2005), 47.6 (2006), 48.9 (2007), 59.1 (2008), 74.4 (2009), 84.0 (2010), 100.0 (2011)
- Net investment position (percent of GDP): -21 (2005), -29 (2006), -23 (2007), -6 (2008), -22 (2009), -24 (2010), -13 (2011)
- Change in the net investment position (memorandum): -4.2 (2005), -8.6 (2006), 3.9 (2007), 17.1 (2008), -15.8 (2009), -3.1 (2010), 9.7 (2011)

### Annex 1 — Estimating hysteresis effects (key finding)
- Finding: Each 1 percentage point widening of the cumulative output gap during persistent and large output gap episodes is associated with an increase in the NAIRU of about 0.14 percentage points.

*UNITED KINGDOM 2012 ARTICLE IV REPORT, INTERNATIONAL MONETARY FUND (content unit _cr12190).*

### 0.1 percent fall in potential output. This effect is linear with respect to the cumulative output gap and

### _cr12190 - 0.1 percent fall in potential output. This effect is linear with respect to the cumulative output gap and

### A. Introduction and context
- Four years after the start of the financial crisis, the level of output in the UK remains below its pre-crisis peak.
- Based on staff estimates, the output gap in the UK has averaged -2¾ percent per year over the last four years.
- The unemployment rate has not increased by as much as would have been expected given the depth of the downturn, but youth unemployment has reached record highs.
- Concern: prolonged slack could erode supply capacity via long-term unemployment (skill erosion), insider-outsider bargaining, and scrapping of idle machinery.

### B. Data and definition of PLOGs
- Data: quarterly OECD data on GDP, unemployment, the output gap, and the NAIRU for 17 advanced economies, spanning 1970:Q1 to 2011:Q4.
- PLOG definition (following Meier, 2010): at least eight consecutive quarters of negative output gaps exceeding 1.5 percent in absolute terms.
- The current UK experience qualifies as a PLOG under this definition.

### C. Stylized facts of PLOGs and NAIRU behavior
- Sample: 28 separate PLOG episodes across the countries (all except Australia experienced at least one episode).
- Average episode duration: 12.4 quarters.
- Average annual output gap during episodes: -3.1 percent.
- Typical dynamics around PLOGs:
  - Output gap trough about a year into the episode, reaching -4 percent on average.
  - Output gap typically closes about three and one-half years after the trough.
  - Unemployment increases on average by about 3½ percentage points during PLOG episodes; peak unemployment is reached about two years into the episode.
  - The average estimated NAIRU increases about 1.1 percentage points over the event window.

### D. Measuring NAIRU changes and methodological adjustments
- To mitigate bias from pre- and post-PLOG abnormal activity, exclude Y years around each PLOG and compute differences using X-year averages before and after the episode.
- Values used: Y = 2 years; X = 3 years.
- Result: NAIRU increases by 1.1 percentage points after a PLOG (consistent with Ball (2009) and Meier (2010)), though with substantial cross-episode variation (e.g., UK GBR(1) ≈ +4 percentage points; UK GBR(2) ≈ -2 percentage points).

### E. Cross-sectional analysis — covariates of NAIRU changes
- Size of PLOG:
  - Change in NAIRU is positively correlated with the cumulative annual output gap (using absolute values for exposition).
  - Regression slope: 0.13 (implying a 1 percent increase in the output gap is associated with a 0.13 percentage point increase in the NAIRU); significance: 1 percent level.
  - Excluding an outlier (Finland) gives slope 0.15; significance: 5 percent level.
- Translation to potential output (production function approach):
  - Cobb-Douglas form used with capital share α = 0.3 (historical UK average) and steady-state NAIRU = 6.3 percent (OECD estimate for the UK in 2008).
  - Result: a 1 percent higher output gap during a PLOG episode is estimated to reduce potential output by 0.1 percent (from the unemployment-channel calculation).
- Nonlinearity test:
  - Including squared output gap terms produced an insignificant coefficient (p-value: 0.54), providing evidence against nonlinear effects of the output gap on NAIRU within PLOGs.
- Labor market institutions (EPL index):
  - EPL: OECD’s Employment Protection Legislation index, scaled 0-6; higher values indicate more regulation.
  - Of 28 PLOG episodes, 15 have EPL data; average EPL in this subset: 2.1.
  - UK’s 1990 PLOG episode EPL: 0.6.
  - Changes in NAIRU are higher for countries with higher EPL.
  - Regression with interaction (change in NAIRU as dependent variable):
    - Cumulative output gap coefficient: -0.04 (standard error 0.08)
    - Cumulative output gap * EPL: 0.09 *** (standard error 0.03)
    - Constant: -0.31 (standard error 0.52)
    - N = 15; R2 = 0.65
    - P-value of impact of output gap on NAIRU at average EPL: 0.01
  - Evaluated at the UK’s current EPL, a 1 percent output gap implies only a 0.01 percentage point increase in the NAIRU (statistically insignificant).

### F. Broader view — potential output and upper bound on hysteresis
- Additional hysteresis channels beyond unemployment include:
  - Fall in labor force participation (discouraged workers dropping out).
  - Lower business investment leading to scrapped capital and non-replacement.
- Method: estimate pre-PLOG trend (five years prior to start of exclusion window), then measure distance between potential output and its trend for up to five years following the PLOG (controls for size of fall).
- Interpretation: this provides an upper bound on hysteresis, since some measured declines could reflect coincident supply shocks rather than demand-driven hysteresis.
- Result: an upper bound estimate of about 0.2 percent decline in potential output for every 1 percentage point of cumulative annual output gap during a PLOG.
  - Figure-based average effect computed following the 2-year exclusion window supports this ~0.2 percent per 1 percentage point estimate.

### G. Conclusions and policy implications
- Unemployment-related hysteresis estimate:
  - Hysteresis from unemployment reduces potential GDP by 0.1 percent for each 1 percentage point increase in the cumulative annual output gap during PLOG episodes.
  - Effects appear linear with respect to the cumulative output gap.
  - Effects are smaller in economies with more flexible labor markets.
- Upper bound from broader potential-output analysis:
  - Upper bound of hysteresis effects is around a 0.2 percent decline in potential GDP for every 1 percentage point increase in the cumulative annual output gap.
- IMF staff judgment for projections:
  - Given the upper bound, the UK’s relatively flexible labor market, and other studies (DeLong and Summers, 2012), IMF staff use a hysteresis coefficient of around 0.1 in current projections.
  - Acknowledgement of substantial uncertainty in both directions; results are suggestive, not conclusive.

*Prepared by Prakash Kannan (EUR); annex to UNITED KINGDOM 2012 ARTICLE IV REPORT — INTERNATIONAL MONETARY FUND*

### Annex 2. The Structural Fiscal Balance and Asset Prices in the

### Annex 2. The Structural Fiscal Balance and Asset Prices in the UK

### Introduction and context
- Purpose: Examine the impact of asset prices on the fiscal balance to improve estimation of the UK’s structural fiscal balance (SFB).
- Rationale: UK is a global financial center with large swings in equity and residential house prices; asset price deviations may affect tax revenue and thus the SFB.
- Current practice: Staff uses the cyclically-adjusted fiscal balance (CAFB) and SFB interchangeably. Staff CAFB uses the Treasury “ready reckoner” formula but with staff’s own output gap estimates.

### Ready-reckoner and cyclical adjustment (explicit formulae)
- Cyclically-adjusted expenditure (t) = expenditure (t) + 0.4 * output gap (t) + 0.1 * output gap (t-1)
- Cyclically-adjusted revenue (t) = revenue (t) - 0.1 * output gap (t) - 0.1 * output gap (t-1)
- Combined ready reckoner for CAFB (percent of GDP):
  - Cyclically-adjusted fiscal balance (t) = fiscal balance (t) - 0.5 * output gap (t) - 0.2 * output gap (t-1)

### Methodology — asset price gap construction and controls
- Equity price gap:
  - Deviation of the Shiller Price Earnings Ratio (PER) for a UK equity price index from its average over the sample period 1981-2011, normalized by that average.
  - Shiller PER = real equity price index / ten-year trailing average of real earnings.
- House price gap:
  - Deviation of the price-to-rent ratio from the price-to-user cost of residential home ownership ratio.
  - Price-to-user cost incorporates i (long-term government bond yields approximation), τ (property tax rate on owner-occupied houses, trailing five-year average), f (recurring holding costs assumed 4 percent), and π (trailing five-year average of CPI and RPI inflation).
- Regression controls:
  - Output gap (WEO database).
  - Statutory tax rates: simple average of personal income tax rates; main corporation tax rate; capital gains tax rate for individuals (simple average of statutory income tax rates for 1988-2008); standard VAT rate.
- Sample and data:
  - Annual data, sample period 1981-2011 for aggregate regression; 1981-2010 or 1981-2011 for individual items as noted.
  - Total Managed Expenditures and tax revenue sources include ONS, Eurostat, HMRC, Datastream, MSCI UK USD, OECD, and IMF staff calculations.

### Aggregate revenue — main regression findings
- Regression (total tax revenue and social contributions-to-GDP on output gap, equity gap, house gap, tax rates; sample 1981-2011) key coefficients and fit:
  - Output gap coefficient: 0.268 **
  - Equity price gap coefficient: 0.018 **
  - House price gap coefficient: 0.008 (not statistically significant)
  - Personal income tax rate: 0.124 ***
  - Corporate tax rate: 0.127 ***
  - Capital gains tax rate: -0.152 ***
  - VAT rate: 0.239
  - Memorandum R2: 0.811
  - Significance notation: *** = 1 percent; ** = 5 percent; * = 10 percent.
- Interpretation and quantified effects:
  - Output gap result (0.27) is similar to ready-reckoner implied coefficient (0.20 when adding contemporaneous and lagged effects).
  - Equity price gap effect: a 50 percent equity price overvaluation temporarily boosts revenue by 0.9 percent of GDP (calculation: 0.018 * 50 = 0.9).
  - House price gap effect: not statistically significant; point estimate implies a 50 percent overvaluation temporarily boosts revenue by 0.4 percent of GDP (calculation: 0.008 * 50 = 0.4).
  - Historical implication: large positive equity price gaps in the late 1990s and mid-2000s artificially boosted revenue; early 1980s negative equity gap reduced revenue.
- Uncertainty in current gap interpretation:
  - The current negative equity price gap (Shiller P/E-based) partly reflects historically high real earnings in the mid-2000s; the 10-year averaging window may temporarily bias the gap measure if pre-crisis earnings fall out of the window.

### Individual revenue items — channels and notable coefficients
- General: Disaggregated regressions produce more noise; many coefficients not statistically significant.
- Notable results:
  - Corporation tax: largest output gap effect — corporation tax is quite procyclical.
  - VAT: equity prices may boost VAT revenue via wealth effects on consumption.
  - Stamp duties: both house and equity prices have non-negligible effects on stamp duties (transaction taxes on asset sales), supporting adjustments for house price gaps at the disaggregated level despite aggregate insignificance.
  - Some anomalous findings: e.g., negative coefficient of equity price gap on social contribution revenue (noted as possibly spurious in a large-coefficient estimation).
- Table A2.2 highlights (selected items and sample periods):
  - R2 by item examples: Other Nonoil Taxes R2 = 0.034 (1981-2010); Capital Taxes R2 = 0.483 (1981-2010); Mandatory Social Contributions R2 = 0.317 (1981-2010); Personal Income Tax R2 = 0.906 (1981-2011); Nonoil Corporation Tax R2 = 0.755 (1981-2011); Capital Gains Tax R2 = 0.306 (1981-2011); VAT R2 = 0.554 (1981-2011); Stamp Duty (SD) R2 = 0.835 (1981-2010).

### Conclusions and policy implications
- Main conclusion: Asset price gaps—especially equity price gaps—have significant effects on revenue and thus warrant closer monitoring in SFB estimation.
- Quantified net effect to date:
  - Offsetting estimated house price overvaluation and equity price undervaluation imply a net effect of asset price gaps on the fiscal balance of less than 0.3 percent of GDP.
- Recommendations:
  - Continued use of the ready-reckoner in staff’s SFB estimates appears broadly appropriate for now.
  - If asset price gaps widen, incorporate asset price gaps more explicitly into SFB estimates.
  - Exercise caution given uncertainty in gap magnitude and measurement (e.g., sensitivity to averaging windows and unusual pre-crisis earnings).

*Prepared by Hajime Takizawa (EUR); Annex 2 content from IMF staff calculations and regressions (sample periods noted in text).*

### Annex 3. Alternative Fiscal Scenarios: Effects of Delaying

### Annex 3. Alternative Fiscal Scenarios: Effects of Delaying Consolidation in the Presence of Hysteresis

### Summary
- The annex simulates an alternative fiscal scenario involving near-term fiscal easing followed by additional medium-term consolidation to restore debt and deficit ratios to baseline levels by 2025.
- Main finding: delaying consolidation yields no gains in cumulative discounted GDP if fiscal multipliers are constant across the cycle, even with substantial hysteresis. Gains may arise if multipliers are asymmetric across the cycle, but can also be negative if multipliers vary with growth and the delayed path makes adjustment more uneven.
- Key calibrated parameters used in simulations: cyclically-adjusted primary balance (CAPB) shock, cumulative stimulus, hysteresis coefficient, multiplier specifications, and output-gap persistence.

### Alternative fiscal scenario (design and calibration)
- Near-term stimulus:
  - CAPB deteriorates by 1 percent of GDP in FY12/13 relative to the previous year and is maintained in FY13/14.
  - Resulting cumulative fiscal stimulus of about 4¼ percent of GDP over those two years relative to the baseline.
- Medium-term response:
  - Starting in FY14/15, fiscal consolidation is phased in to return both debt and deficit to baseline levels by 2025.
  - Restoring the debt-to-GDP ratio to baseline by 2025 is a central constraint distinguishing this analysis from DeLong and Summers (2012).
- Hysteresis assumption:
  - Each 1 percent output gap reduces potential GDP by 0.1 percent annually (the central hysteresis parameter).
- Output-gap dynamics and growth calculation:
  - In absence of shocks, the output gap is assumed to close by half each year (output-gap persistence = 0.5).
  - Example growth calculation provided: if potential growth = 1.7 percent, output gap = -2 percent, fiscal headwind = 0.4 percent, then growth = 2.3 percent (1.7 + 2*.5 - .4 = 2.3).
- Baseline calibrated to staff’s central scenario; fiscal balances respond to growth in line with automatic stabilizers used by HM Treasury and staff.

### Results — Symmetric multipliers
- Constant-multiplier case (Alternative 1):
  - Multiplier constant at 0.8.
  - Result: no benefit to delaying consolidation. Potential GDP in 2025 and cumulative discounted GDP during 2011-25 are no better than in the baseline.
- Intuition:
  - If multipliers and hysteresis effects are symmetric, stimulus-phase gains are reversed during the inevitable consolidation phase required to return debt to baseline, eliminating permanent gains.

### Results — Asymmetric multipliers
- Multiplier varying with the output gap (Alternative 2):
  - Multiplier rises linearly from 0.15 when the output gap is +3 percent to 1.2 when the output gap is -4 percent.
  - Outcome: cumulative discounted GDP during 2011-25 under delayed consolidation is 0.25 percent higher than under the baseline.
  - Note: multipliers in all three alternatives are calibrated so that they are 0.8 on average during the projection period.
- Multiplier varying with GDP growth (Alternative 3):
  - Multiplier rises linearly from zero when growth is +5 percent to 1.5 when growth is -1 percent.
  - Outcome: gains from delaying consolidation are negative: -0.25 percent of cumulative discounted GDP during 2011-25.
- Mechanism for negative outcome in Alternative 3:
  - Baseline projects moderately positive and broadly stable growth, implying broadly constant multipliers; therefore limited upside from stimulus.
  - Delaying consolidation makes the consolidation phase steeper (more uneven) than under the baseline, leading to larger fiscal headwinds and lower growth during consolidation.
  - Lower growth raises fiscal multipliers in the consolidation phase, further depressing growth and raising multipliers in a reinforcing feedback.
- Downturn caveat:
  - If growth turns decisively negative, multipliers would spike under the growth-sensitive specification and simulations suggest permanent gains from fiscal stimulus could exceed 1 percent of potential GDP.

### Sensitivity tests
- Central calibration points: hysteresis coefficient = 0.1; output-gap persistence = 0.5.
- Findings from varying these parameters:
  - Under symmetric multipliers (Alternative 1): essentially no gains from delaying consolidation even with large hysteresis effects or highly persistent output gaps.
  - Under output-gap–sensitive asymmetric multipliers (Alternative 2): larger hysteresis effects and slower natural closing of output gaps amplify potential gains from delaying consolidation.
  - Under growth-sensitive multipliers (Alternative 3): large hysteresis effects and persistent output gaps magnify the losses from delaying consolidation, particularly given the baseline’s positive and relatively stable growth path.

### Comparing gains with costs (nonmodeled risks and considerations)
- Nonmodeled costs of temporarily higher debt/deficits include:
  - Higher risk premia.
  - Crowding out effects on capital accumulation.
  - Reduced buffers to deal with unexpected adverse shocks.
  - Political economy risks that delayed consolidation may never be delivered.
- Current assessment of UK-specific asymmetry and monetary offset:
  - The degree of multiplier asymmetry in the UK is uncertain.
  - Spring 2012 Fiscal Monitor found little multiplier asymmetry in the UK across the output gap.
  - Auerbach and Gorodnichenko (2012) find multiplier asymmetry vanishes as debt approaches 100 percent of GDP—a level the UK is approaching.
  - Monetary policy effectiveness matters: if UK monetary policy can offset fiscal decisions (via broad monetary and credit easing), fiscal multipliers may be relatively low and symmetric; failure of monetary and credit easing to improve growth could indicate greater multiplier asymmetry related to the zero lower bound and strengthen the case for slowing fiscal tightening.
- Credibility recommendation:
  - Any reconsideration of the consolidation path should be embedded in a multi-year plan focused on further reducing the UK's large structural fiscal deficit when the economy is stronger and should consider risks to sovereign borrowing costs and other factors.

*Prepared by Kevin Fletcher and Damiano Sandri (EUR); based on IMF staff simulations described in the annex.*

### Annex 4. FSAP Update: Status of Main Recommendations

### Annex 4. FSAP Update: Status of Main Recommendations

### Overall Financial Sector Oversight
- Summary: Reorganization of regulatory architecture progressing; operational separation of FSA into PRA and FCA underway. Transition and revision of supervisory program are major undertakings; many FSAP recommendations to be addressed when work is finalized. Successful implementation requires significant staff resources for both new authorities.
- Recommendations and status:
  - Revise the legal framework to clarify mandates and include a specific financial stability mandate for the prudential authorities (Tripartite).
    - Priority: High
    - Timeframe: Immediate
    - Status: Substantial progress in defining mandates. PRA will be a subsidiary of the BoE; PRA responsible for prudential supervision of commercial banks, building societies, and insurance companies, as well as investment firms deemed systemically important. PRA objectives: promoting the safety and soundness of regulated firms; policyholder protection. FCA responsible for prudential regulation of around 25,000 firms not prudentially regulated by the PRA, including several thousand investment firms. FCA single strategic objective: protecting and enhancing confidence in the UK’s financial system; three operational objectives: (i) securing an appropriate degree of protection for consumers; (ii) promoting efficiency and choice in the market of financial services; and (iii) protecting and enhancing the integrity of the UK financial system. Objectives are not explicitly linked to financial stability; concerns from the FSAP about lack of priority around financial stability responsibilities are not yet fully addressed. FCA chair participates in the Financial Policy Committee (FPC).
  - Amend legislation to allow for regulatory power over holding companies of regulated entities (Her Majesty’s Treasury (HMT)).
    - Priority: High
    - Timeframe: Near term
    - Status: Draft Financial Services Bill contains provisions (section 192) improving on current restrictions but limits powers to the “power of direction” under specific conditions; does not extend to full authority over holding companies. BoE and FSA expressed concern that the Bill does not give the PRA sufficient power. HMT will revisit issue in context of future European-level work.
  - Enhance resources for supervision of banks, insurers, and securities firms based on the agreed-upon supervisory operating model and the new macro-prudential overlay (Tripartite).
    - Priority: High
    - Timeframe: Near term
    - Status: No plans to increase personnel resources for PRA/FCA beyond present FSA level. Both agencies under pressure not to expand budgets; concern about sufficiency of resources remains. Upcoming statement on PRA recruitment and strategy expected.
  - Establish a forum for ensuring good governance and coordination among organizations in the new regulatory structure (HMT).
    - Priority: High
    - Timeframe: Near term
    - Status: Draft Financial Services Bill requires PRA and FCA to enter into a memorandum of understanding (MoU) setting out a high-level framework. Draft MoU produced by BoE and FSA. FSA implemented an “internal twin peaks model” as of April 2012 to separate future FCA and PRA within FSA. MoU requires each regulator to appoint a senior executive responsible for coordination; appointees to meet quarterly (first year: respective CEOs). Boards review MoU effectiveness annually; annual reports must account for cooperation. Bill grants PRA veto over FCA decisions where financial stability issues at stake; both PRA and FCA represented at FPC. In crisis, BoE subject to additional reporting to HMT; when certain criteria met HMT can direct some BoE operations—impact on PRA unclear. Financial Services Bill is draft and subject to change.
  - Enforce public disclosure by banks and insurance and securities firms, including prudential returns as appropriate (FSA).
    - Priority: High
    - Timeframe: Near term
    - Status: PRA will prioritize strengthening disclosure; future PRA staff identifying data needs and will revise disclosure requirements to ensure comparability across firms and through time. PRA will seek to publish some regulatory returns. Project in early stages.
  - Amend risk-based assessment methodologies to ensure adequate assessment of AML/CFT risk (FSA).
    - Priority: High
    - Timeframe: Near term
    - Status: Revision of risk-based assessment methodology is on-going and not yet complete.

### Banking Oversight
- Summary: Future PRA developing high-level supervisory model with firm categorization and a more proactive, judgment-based, forward-looking supervisory regime. Resource allocation and full operationalization remain works in progress.
- Recommendations and status:
  - Enhance supervision by (i) conducting detailed reviews of credit and market risk assessment by banks, (ii) conducting verification and selected model replication reviews on a proactive basis, (iii) better integrating specialist work into the supervision program, and (iv) enhancing peer analysis (FSA).
    - Priority: High
    - Timeframe: Near term
    - Status: PRA supervisory model designates firms Category 1-4 by size/complexity/impact. Category 1 supervisory assessment framework: systematic, proactive, multi-year, more continuous onsite assurance, judgment-based and forward-looking. PRA committed to more senior management involvement in direct supervision. Supervisory assessment framework to construct multi-year plans covering different risk areas and testing credit/market risk as necessary. Frequency and depth of reviews depend on further framework design and resource allocations. Specialists and supervisors better integrated; capital and liquidity assessments to be linked to overall bank assessment. PRA will not replicate internal models but will subject outputs of important models to regular review and Hypothetical Portfolio Exercises. Board-level interaction to be more frequent and led by Director (or above). Completing and operationalizing supervisory approach to take several years.
  - Adopt a proactive intervention framework through triggers for contacts and coordination actions with other authorities and amend legislation as needed (FSA).
    - Priority: Medium
    - Timeframe: Medium term
    - Status: PRA will establish a Proactive Intervention Framework (PIF) for all regulated institutions to support early identification of risks to firm viability and ensure remedial action. PIF will flag preparatory actions for failure/resolution coordination with SRU and FSCS. Supervisors report to PRA senior management where expected actions not taken. PIF expected to have five stages; placement based on assessment of firm’s viability in current and future states (not mechanically reliant on backward-looking indicators). Assessment reflects expected financial strength in stressed circumstances and will be revisited as needed. Stage 1 implies low risk and normal monitoring. PIF planning underway; full operationalization will take time.
  - Develop a comprehensive plan to enhance prudential reporting and conduct a review to deliver a more systematic approach to data quality (FSA).
    - Priority: High
    - Timeframe: Near term
    - Status: FSA and BoE initiated project to define PRA steady-state data requirements across the risk assessment model from potential impact analysis to resolution. Plan to store/classify/quality-assure data in BoE statistics division. Requirements to be compared and reconciled with European requirements (e.g., COREP). Initial consultation document to be published in September.

### Insurance Sector Oversight
- Recommendations and status:
  - Extend the new intrusive risk-based approach to supervision to a wider range of insurers (FSA).
    - Priority: High
    - Timeframe: Near term
    - Status: Redesignation under Categories 1-5 likely to increase number of insurers subject to intensive supervision (Category 1 and 2). Once PRA supervisory model in place, it may address FSAP concerns that insurers just below current CPP(I) threshold are insufficiently supervised.
  - Increase the frequency and number of randomly conducted “transaction examinations” for both the largest and some smaller insurers (FSA).
    - Priority: Medium
    - Timeframe: Medium term
    - Status: PRA supervisory design has not yet reached this level of detail.

### Securities Markets Oversight
- Recommendations and status:
  - Clarify in legislation that the remit of the conduct authority includes market integrity and transparency to ensure adequate emphasis on issues other than consumer protection (HMT).
    - Priority: High
    - Timeframe: Immediate
    - Status: Launch documents suggest FCA mandate includes clear responsibility for market integrity and transparency, as well as consumer protection. Concern remains that FCA mandate does not contain sufficient emphasis on prudential responsibilities.
  - Increase intensity of supervision with greater use of “bottom up” analysis of firm operations using on-site examinations, including thematic work, to supplement the “top down” risk analysis (FSA).
    - Priority: High
    - Timeframe: Medium term
    - Status: FCA supervisory model still under design. Early indications: due to large number of firms and resource constraints, FCA will not expand “bottom up” analysis of small firms; will expand thematic reviews and revise data reporting. Large range of firms will continue to have low contact.

### Payments and Securities Systems Oversight
- Recommendations and status:
  - Ensure that sufficient and reliable funding options are in place for central counterparties (CCPs), including committed credit lines subject only to presentment (Bank of England (BoE), FSA).
    - Priority: High
    - Timeframe: Near term
    - Status: FSA reviewing liquidity standards at CCPs; instituted liquidity stress testing program and monthly liquidity reporting. Rather than requiring committed credit lines, CCPs required to hold additional highly liquid collateral, aligning with CPSS/IOSCO standards. FSA (with BoE input) conducting detailed examinations of CCP liquidity risk management. Supervision of CCPs to pass to BoE at end of transition.
  - Develop contingency plans to deal with a potential failure of a CCP (BoE, FSA).
    - Priority: High
    - Timeframe: Near term
    - Status: Contingency planning ongoing. Authorities active in EU and FSB work. CCPs developing loss allocation rules for losses beyond standard default protections; some CCPs already have such rules. FSA expects European-level legislation on CCP resolution; CPSS/IOSCO working on issues.
  - Offer central bank settlement to CCPs that have been classified as systemic institutions (BoE).
    - Priority: Medium
    - Timeframe: Medium term
    - Status: BoE ready to offer sterling concentration facilities to systemic CCPs and is reviewing policy framework for provision of services to CCPs generally.
  - Establish close monitoring of concentration of banks’ payment and settlements activities (BoE, FSA).
    - Priority: Medium
    - Timeframe: Near term
    - Status: BoE to become sole overseer of payment and settlement activities. BoE developed indicators to monitor concentration; BoE shares tiering data with FSA. CHAPS Co introduced rules/criteria to preclude indirect relationships posing unacceptable systemic risk and will assess against criteria by September. EUI analyzing tiering data and will make recommendations. CHAPS Co and EUI discussing membership with major banks.
  - Undertake a unified assessment of the real time gross settlement (RTGS) infrastructure, including an assessment of the finality of transactions (BoE).
    - Priority: High
    - Timeframe: Medium term
    - Status: Assessment not yet undertaken. BoE will conduct such assessments under its own risk framework.

### Crisis Management
- Recommendations and status:
  - Establish appropriate resolution tools and framework for potentially systemically important nonbank firms that are not covered by the Special Resolution Regime (Tripartite).
    - Priority: Medium
    - Timeframe: Medium term
    - Status: Revisions to resolution framework ongoing. Independent Commission on Banking recommendations will require ring-fencing of retail deposit business in large banks and additional loss-absorbency for systemically important institutions; recommendations being considered for legislation planned for 2015. Bail-in aspects may fold into EU resolution framework work. Large UK banks are finalizing resolution and recovery plans.

*Prepared by Jennifer Elliot (MCM).*

### Annex 5. Spillovers: Financial Contagion Through G-SIBs

### Annex 5. Spillovers: Financial Contagion Through G-SIBs

### Key findings and framing
- Spillovers emanating from the UK are "almost entirely financial" and "UK financial stability is a global public good, requiring the highest quality supervision and regulation."
- Given the centrality and size of the UK banking sector, UK global systemically important banks (G-SIBs) are assessed as potential sources and propagators of shocks.
- The analysis uses a sample of 32 SIBs (27 G-SIBs and 5 European SIBs) and constructs two sets of metrics:
  - Directional correlations of market prices, measuring an institution’s contribution to the variance of other institutions’ equity returns (contribution to systemic risk) in normal times and during high stress episodes.
  - Balance sheet indicators of interconnectedness based on the size of securities holdings and wholesale funding liabilities, and of vulnerability to a number of risk factors.
- The analysis identifies two UK G-SIBs as having "great capacity to generate spillovers." These two UK institutions are also among the most susceptible to spillovers from others, but "are more likely to be affected mainly during times of market stress, including dislocations in funding markets or a generalized sell-off in broader asset markets."

### Banks with high spillover potential and interconnectedness
- Two UK G-SIBs are identified among the institutions with high potential to generate spillovers.
- In addition to the two UK G-SIBs, four euro area and four US G-SIBs are identified as having high potential to generate spillovers.
- UK G-SIBs have grown in size and importance over the last decade and are highly interconnected with the rest of the global financial system; therefore, spillovers from European shocks transmitted through UK G-SIBs "could potentially be very large."

### Deleveraging due to funding and sovereign stress — scenarios and impacts
- To examine transmission channels, contagion effects of sovereign and funding shocks to European G-SIBs are simulated.
- General observation: A freeze of wholesale funding markets would hit UK banks particularly hard, exacerbating UK banks’ deleveraging both in the UK and outside. In contrast, a sovereign shock would affect the UK indirectly through stress and deleveraging of foreign banks.

- Sovereign shock scenario:
  - Assumption: A permanent decline in sovereign bond prices in Italy and Spain equal to the difference between prices in December 2011 and March 2012.
  - Result: Several G-SIBs in the euro area core plus banks in the periphery incur large losses.
  - Deleveraging is largest in the periphery, followed by Germany and the UK.
  - "The impact outside of Europe is, however, relatively modest."

- Funding shock scenario:
  - Shock composition: A sharp increase in LIBOR-OIS spreads, calibrated to the Lehman stress episode, and a reduction in the value of derivatives market funding.
  - Bank losses are largest in France, Germany, and the UK.
  - The ensuing deleveraging "exceeds 10 percent of GDP" in these countries as well as in emerging Europe.
  - Deleveraging outside Europe is more modest, but still large in the US, Japan, Australia, and several emerging market economies.

### Policy implication highlighted in the annex
- UK financial stability being a global public good implies the need for "the highest quality supervision and regulation" of UK banks, particularly given the potential for amplification of euro area shocks via UK G-SIBs.

### Supplementary update from BoE Financial Stability Report (June 29)
- The Bank of England’s semi-annual Financial Stability Report (FSR):
  - Notes that UK banks’ efforts to strengthen capital and funding resilience have helped insulate them from economic weakness and intensified euro area stress since end-2011.
  - Nonetheless, the FSR finds that the outlook for financial stability has deteriorated since end-2011, with both funding costs and risks of severe downside scenarios on the rise.
  - The FSR and the latest credit survey find that credit growth remains weak and that credit supply has tightened further in recent months.

---

### Annex 6. Fiscal Debt Sustainability Analysis (selected projections and scenarios)

### Baseline projections under staff’s central macroeconomic scenario and the government’s fiscal plans
- General government primary deficit is expected to continue improving to a surplus of 2¼ percent of GDP by FY17/18.
- General government gross debt is projected to:
  - Reach a peak of about 96 percent of GDP before declining to 92½ percent of GDP by FY17/18.

### Alternative scenarios and sensitivity
- No fiscal consolidation (constant primary balance over FY12/13–17/18):
  - Debt would increase to 115 percent of GDP by FY17/18 and be on a firm upward path.
- Interest rate sensitivity:
  - "Medium-term debt dynamics are not highly sensitive to interest rate shocks given the long average maturity (14 years) of UK government debt."
- Growth shock sensitivity:
  - If medium-term growth rates are persistently lower, stabilizing the debt ratio would require further adjustment.
  - Assuming expenditure plans unchanged, the debt-to-GDP ratio could reach 105 percent of GDP by FY17/18 should growth be "1.3 percentage points (½ a standard deviation) lower each year than in the central scenario."

### Baseline table highlights (General government consolidated gross debt; percent of GDP)
- Baseline series (selected years):
  - 2007: 42.9
  - 2008: 56.0
  - 2009: 71.3
  - 2010: 76.6
  - 2011: 84.3
  - 2012: 89.7
  - 2013: 93.8
  - 2014: 95.8
  - 2015: 96.0
  - 2016: 94.8
  - 2017: 92.5
- Debt-stabilizing primary balance (percent of GDP) in 2017: -1.2

### Selected fiscal and macro assumptions (baseline)
- Real GDP growth (in percent), selected years:
  - 2007: 3.6
  - 2008: -3.6
  - 2009: -2.4
  - 2010: 2.2
  - 2011: 0.2
  - 2012: 0.6
  - 2013: 1.5
  - 2014: 2.4
  - 2015: 2.6
  - 2016: 2.6
  - 2017: 2.7
- Average nominal interest rate on public debt (in percent), selected years:
  - 2007: 5.4
  - 2008: 5.0
  - 2009: 3.8
  - 2010: 4.3
  - 2011: 4.3
  - 2012: 3.6
  - 2013: 3.5
  - 2014: 3.7
  - 2015: 3.7
  - 2016: 3.9
  - 2017: 4.0
- Inflation rate (GDP deflator, in percent), baseline:
  - 2007: 2.3
  - 2008: 3.0
  - 2009: 1.8
  - 2010: 2.7
  - 2011: 2.3
  - 2012: 2.7
  - 2013–2017: 2.6, 2.5, 2.5, 2.5, 2.5 (respectively)
- Growth of real primary spending (deflated by GDP deflator, in percent), selected years:
  - 2007: 3.5
  - 2008: 6.0
  - 2009: 4.4
  - 2010: -2.4
  - 2011: -1.7
  - 2012: 0.5
  - 2013: -1.7
  - 2014: -1.5
  - 2015: -1.9
  - 2016: -1.3
  - 2017: -0.1

### Alternative scenario outcomes (selected)
- Scenario with no policy change (constant primary balance) in 2012–2017:
  - Debt path referenced: 89.7 (2012), 95.1 (2013), 100.1 (2014), 104.9 (2015), 109.9 (2016), 114.7 (2017).
- Scenario with key variables at their historical averages:
  - Debt path referenced: 89.7 (2012), 94.6 (2013), 99.8 (2014), 105.1 (2015), 110.6 (2016), 116.0 (2017).

---

*Annex 5 and Annex 6, "Spillovers: Financial Contagion Through G-SIBs" and "Fiscal Debt Sustainability Analysis," from the United Kingdom: 2012 Article IV Report — Informational Annex.*

### 2.      Against this background and consistent with staff recommendations

### _cr12190 - 2.      Against this background and consistent with staff recommendations

### Interim Financial Policy Committee (FPC) recommendations (paragraphs 49–51 of the staff report)
- The FPC recommended that the Financial Services Authority (FSA) should:
  - make clearer to banks that liquidity buffers should be used in times of stress to avoid excessive credit contraction.
    - Footnote: Many banks are currently maintaining levels of liquidity in excess of regulatory minima, reflecting in part conservative risk management.
  - review banks’ liquidity guidelines to account for the availability of BoE liquidity insurance.
  - continue its existing practice of encouraging banks to bolster capital buffers via methods that do not curtail lending to the real economy; the minutes of the FPC meeting are explicit that banks should not be “constrained by regulatory capital requirements from expanding lending”.
    - Such methods include equity issuance, debt-for-equity swaps, and restraint of dividends and remuneration.
    - The FPC expected that part of additional capital should be used to increase capital ratios to insure against heightened risks and reduce funding costs and that part could be used to expand lending.
  - clarify that such higher capital levels above the official Basel III transition path were a temporary response to heightened risks and that banks could revert to the original transition path once such risks materialize or dissipate.

### Monetary Policy Committee (MPC) meeting
- On July 5, the MPC voted to raise its purchases of government bonds by £50 billion to a total of £375 billion.
- Purchases will be spread evenly over the next four months and be distributed across maturities in the same manner as the last round of purchases.
- The MPC stated such easing was necessary to keep inflation from undershooting the target in the medium term, given “continuing tight credit conditions and fiscal consolidation,” as well as “increased drag from the heightened tensions within the euro area.”
- Staff welcomes this easing, as called for in the staff report (paragraphs 27–28).
- The forthcoming Funding for Lending program should help further support the outlook.
- It will be difficult to assess the adequacy of the total package of measures until the Funding for Lending program goes into effect.
- The announcement of additional QE was anticipated by markets, and hence their reaction was muted.

### GDP and fiscal data releases
- Recent data releases include revisions to historical GDP data and fiscal outturns for FY11/12.
- Main changes arising from these releases:
  - the 2008–09 recession is now moderately more shallow than previously estimated, with the peak-to-trough decline falling from 7 percent to 6¼ percent;
  - the overall fiscal deficit for FY11/12 is now estimated at 8.4 percent of GDP, slightly higher than staff’s previous estimate of 8.2 percent of GDP (staff report Table 3) due to modest deviations on both revenue and expenditure.
- These data revisions do not significantly alter staff’s projections, analysis, or views in the staff report.

### Attempted manipulation of LIBOR and EURIBOR
- Following an investigation, UK and US regulators recently fined Barclays for attempting to manipulate LIBOR and EURIBOR interest rates and for false reporting.
  - The investigation concluded that Barclays misconduct included:
    - making submissions which formed part of the LIBOR and EURIBOR setting process that took into account requests from Barclays’ interest rate derivatives traders; these traders were motivated by profit and sought to benefit Barclays’ trading positions;
    - seeking to influence the EURIBOR submissions of other banks contributing to the rate setting process;
    - reducing its LIBOR submissions during the financial turmoil of 2007-09 as a result of senior management’s concerns over negative media comment.
  - Barclays’ top executives have resigned, reportedly at the behest of regulators.
  - Media reports indicate that around 20 other banks, including major US and European banks, are under investigation for similar practices.
  - The collaboration of US and UK regulators in the investigation is welcome, and further international cooperation along these lines is encouraged.
  - Footnote: More information can be found in the FSA press release and the press release by the US Commodity Futures Trading Commission.

### Implications and recommended next steps
- The findings of the investigation are disturbing and may have spillovers:
  - With an enormous volume of derivatives and loans linked to benchmarks such as LIBOR and EURIBOR, accurate determination is essential to ensure faith in their integrity.
  - Otherwise, use of such benchmarks, which facilitate automatic adjustment of contracts to changing conditions, will be lessened and their usefulness degraded.
  - In the near term, such revelations could add to deleveraging pressures, as uncertainty about potential losses from forthcoming regulatory penalties and potential lawsuits may increase bank borrowing costs.
  - Uncertainty about key benchmarks could increase some spreads and volatility in related contracts.
  - Such pressures may in turn have unwelcome adverse effects on credit conditions, both in the UK and abroad, especially given the relatively rapid diffusion of shocks originating on the UK’s platform, as discussed in the 2012 Spillover Report.
- Hence it is appropriate that reforms to ensure the integrity of interest rate determination are being contemplated.
- A complete assessment of the implications should await the conclusion of ongoing investigations and the release of all facts.

*International Monetary Fund — 2012 ARTICLE IV REPORT—SUPPLEMENTARY INFORMATION, UNITED KINGDOM (July 10, 2012).*

### Box 2.2 of the October 2008 Global Financial Stability Report

### Box 2.2 of the October 2008 Global Financial Stability Report

### LIBOR setting and inquiries
- Chancellor Osborne announced an inquiry to examine whether the setting of LIBOR should become a regulated activity and whether actual trade data could be used to set the benchmark.  
- The inquiry is to be completed by September so proposals can be incorporated into the final Financial Services Bill.  
- A parliamentary investigation into the attempted manipulation will feed into legislation to implement reforms proposed by the Independent Commission on Banking.

### Funding for Lending Scheme (FLS) — design and terms
- Announced by the Bank of England and UK Treasury on July 13, 2012.  
- Objective: reduce funding costs for banks and building societies so they can make loans cheaper and more easily available; access linked to how much each bank/building society lends to the real economy.  
- Operational dates: from August 1 (and for 18 months thereafter).  
- Swap mechanics:
  - Banks can swap up to 5 percent of their existing stock of loans to the non-financial sector as at end-June 2012 (amounting to around £80bn) for T-bills.
  - Banks can also swap unlimited amounts for new lending.  
- Collateral and pricing:
  - Funding provided against a wide range of collateral, with haircuts applied on the same terms as the BoE’s existing Sterling Monetary Framework.
  - Swap term: fixed term of four years.
  - Fee depends on banks’ lending behavior during reference period of end-June 2012 through the end of 2013.
  - Fee for banks maintaining or expanding lending: 0.25 percent per year on the amount borrowed.
  - Fee for banks whose lending declines: increases linearly up to a maximum fee of 1.5 percent of the amount borrowed.
  - With banks able to use T-bills to borrow money at rates close to the expected path of the policy rate (now at 0.5 percent), the total cost of obtaining cash under the scheme will vary between 0.75 and 2 percent.
- Transparency: The BoE will publish participants’ outstanding drawings under the scheme on a quarterly basis.
- Policy intent and features:
  - Pricing designed to encourage expansion of net lending.
  - If banks maintain or expand lending, the lower fee of 0.25 percent will apply to all funding they obtain through the scheme, not just incremental funding.
  - FLS loans are for four years, longer than other facilities such as the ECTR (6-month funding).
  - Expected to help keep funding costs low for the target market, though final effects on demand and growth are unclear.

### IMF Public Information Notice (PIN) — Executive Board conclusion (July 16, 2012)
- The Executive Board concluded the 2012 Article IV consultation with the United Kingdom on July 16, 2012.  
- Background assessment:
  - Recovery sluggish; hand-off from public to private demand-led growth has not fully materialized.
  - Economic activity projected to gain modest momentum but pace expected to be weak relative to underutilized resources.
  - Output gap projected to remain sizeable for an extended period; unemployment currently over 8 percent and expected to stay elevated.
  - Inflation on downward trend since peaking in September 2011 and expected to decline below the 2 percent target over the medium term.
  - Risks predominantly to the downside, including euro area setbacks and larger-than-expected deleveraging headwinds.
- Policy context:
  - Structural fiscal adjustment of about 4¾ percent of GDP over the last two years.
  - Pace of consolidation expected to ease to ½ percent of GDP in FY2012/13; accelerate next year to around 1½ percent of GDP under current plans.
  - Bank of England resumed purchases of government bonds (quantitative easing) in late 2011 with additional purchases announced in February and July 2012.
  - Credit conditions remain tight; authorities announced credit easing measures including broader provision of bank funding and liquidity.
  - Financial Services Bill expected to provide permanent legal basis for new regulatory framework in early 2013; White Paper on Banking Reform published with proposals for additional loss absorbency and ringfencing of retail operations.

### Executive Board assessment and recommendations
- General endorsement:
  - Directors welcomed efforts toward economic rebalancing, bold monetary stimulus, financial sector policies to build buffers and strengthen oversight, and progress toward fiscal sustainability.
- Monetary policy:
  - Directors welcomed announcements of further quantitative easing; most believed further easing may be needed, including consideration of a cut in the policy rate.
  - Some Directors cautioned scope for more stimulus via rate cuts and standard quantitative easing may be limited given very low government debt rates.
- Credit easing and bank funding:
  - Directors welcomed measures aimed at lowering private-sector borrowing costs through broader provision of bank funding against collateral.
  - Emphasized such measures should be complemented with regulatory policies to avoid bank dependence on facilities.
- Fiscal policy:
  - Directors considered deeper budget-neutral reallocations could support recovery, including greater investment funded by property tax reform or cuts on items with low multipliers.
  - Emphasized automatic stabilizers should operate freely and poorest should be shielded from consolidation impacts.
  - Many Directors supported prudent approach toward fiscal easing to preserve fiscal sustainability and credibility; a number of other Directors argued consolidation should not be accelerated if growth fails to build momentum even after additional easing.
  - Any adjustment to consolidation path should be in context of a multi-year plan and ideally accompanied by deeper long-run entitlement reform.
- Financial stability and regulation:
  - Stressed continuing efforts to bolster financial stability, focusing on strengthening bank balance sheets by building capital rather than reducing assets.
  - Welcomed review of banks’ liquidity guidelines to account for Bank of England liquidity insurance availability.
  - Emphasized need to address "too big to fail" expeditiously: progress on flexible resolution framework, "living wills", and Independent Commission on Banking proposals welcomed.
  - Supported a broader macroprudential toolkit for the Financial Policy Committee, including powers to limit loan-to-value and loan-to-income ratios.
  - Supported intensifying supervision and providing adequate resources; greater authority over financial holding companies for the future Prudential Regulatory Authority deemed essential.
  - Encouraged continued international collaboration on regulatory and supervisory issues.

### Selected economic indicators (2008–13) — key figures (as presented)
- Real Economy:
  - Real GDP (change in percent): 2008 -1.1; 2009 -4.4; 2010 2.1; 2011 0.7; 2012 Proj. 0.2; 2013 Proj. 1.4.
  - Domestic demand (change in percent): 2008 -1.8; 2009 -5.4; 2010 2.9; 2011 -0.8; 2012 Proj. -0.1; 2013 Proj. 0.6.
  - CPI (change in percent, period average): 2008 3.6; 2009 2.1; 2010 3.3; 2011 4.5; 2012 Proj. 2.6; 2013 Proj. 1.9.
  - Unemployment rate (percent) 2/: 2008 5.6; 2009 7.5; 2010 7.9; 2011 8.0; 2012 Proj. 8.3; 2013 Proj. 8.3.
  - Gross national saving (percent of GDP): 2008 15.6; 2009 12.7; 2010 12.1; 2011 12.9; 2012 Proj. 11.6; 2013 Proj. 12.6.
  - Gross domestic investment (percent of GDP): 2008 17.0; 2009 14.2; 2010 15.4; 2011 14.8; 2012 Proj. 14.2; 2013 Proj. 14.4.
- Public Finance 3/:
  - General government balance: 2008 -6.9; 2009 -11.4; 2010 -9.4; 2011 -8.4; 2012 Proj. -8.1; 2013 Proj. -6.8.
  - Public sector balance: 2008 -6.9; 2009 -11.1; 2010 -9.3; 2011 -8.2; 2012 Proj. -8.0; 2013 Proj. -6.7.
  - Cyclically adjusted balance (staff estimates): 2008 -7.8; 2009 -10.1; 2010 -7.8; 2011 -6.2; 2012 Proj. -5.4; 2013 Proj. -3.9.
  - Public sector net debt: 2008 43.5; 2009 52.6; 2010 60.5; 2011 66.6; 2012 Proj. 71.9; 2013 Proj. 76.4.
- Money and Credit (end-period, 12-month percent change) 4/:
  - M4: 2008 15.5; 2009 6.7; 2010 -1.5; 2011 -2.5; 2012 -3.8.
  - Net lending to the private sector: 2008 5.0; 2009 0.5; 2010 -0.4; 2011 -0.2; 2012 -0.4.
- Interest rates (year average) 4/:
  - Three-month interbank rate: 2008 5.8; 2009 1.2; 2010 0.7; 2011 0.9; 2012 1.1.
  - Ten-year government bond yield: 2008 4.7; 2009 3.6; 2010 3.6; 2011 3.1; 2012 2.2.
- Balance of Payments:
  - Trade balance (percent of GDP): 2008 -2.7; 2009 -1.8; 2010 -2.5; 2011 -1.8; 2012 Proj. -1.8; 2013 Proj. -0.9.
  - Current account balance (percent of GDP): 2008 -1.4; 2009 -1.5; 2010 -3.3; 2011 -1.9; 2012 Proj. -2.6; 2013 Proj. -1.8.
  - Exports (percent of GDP): 2008 29.5; 2009 28.4; 2010 30.1; 2011 32.3; 2012 Proj. 32.0; 2013 Proj. 31.8.
  - Export volume (change in percent): 2008 1.3; 2009 -9.5; 2010 7.4; 2011 4.6; 2012 Proj. 1.6; 2013 Proj. 3.8.
  - Imports (percent of GDP): 2008 32.2; 2009 30.2; 2010 32.6; 2011 34.2; 2012 Proj. 33.7; 2013 Proj. 32.8.
  - Import volume (change in percent): 2008 -1.2; 2009 -12.2; 2010 8.6; 2011 1.2; 2012 Proj. 1.3; 2013 Proj. 1.3.
  - Net exports of oil (billions of US dollars): 2008 -12.0; 2009 -5.4; 2010 -7.3; 2011 -17.9; 2012 Proj. -15.9; 2013 Proj. -15.1.
  - Reserves (end of period, billions of US dollars): 2008 53.9; 2009 66.4; 2010 78.8; 2011 93.9.
- Fund Position (as of May 31, 2012):
  - Holdings of currency (percent of quota): 64.8.
  - Holdings of SDRs (percent of allocation): 94.4.
  - Quota (millions of SDRs): 10,738.5.
- Exchange Rates:
  - Exchange rate regime: Floating.
  - Bilateral rate (June 13, 2012): US$1 = £0.6417.
  - Nominal effective rate (2005=100) 4/ 5/: 2008 89.3; 2009 78.8; 2010 79.3; 2011 78.7; 2012 80.6.
  - Real effective rate (2005=100) 4/ 5/ 6/: 2008 92.1; 2009 80.8; 2010 83.7; 2011 84.9; 2012 87.4.
- Social Indicators (reference year):
  - Income per capita (in US dollars, 2010): 36,416.
  - Income distribution (ratio of income received by top and 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.

### Statement by the UK authorities and policy positions (July 16, 2012)
- Economic outlook and policy stance:
  - Authorities estimate contraction of 0.3 per cent in each of the last two quarters; growth over past 18 months broadly flat.
  - Unemployment fell by 51,000 to 8.2 per cent in three months to April; 166,000 new jobs created.
  - OBR forecast (March): growth of 0.8 per cent for 2012, 2.0 per cent in 2013, and 2.7 per cent in 2014.
  - CPI inflation fell to 2.8 per cent in May from peak of 5.2 per cent in September 2011.
  - Authorities agree exceptional environment warrants supportive macroeconomic stance based on: fiscal consolidation; monetary activism; financial sector reform; growth-friendly microeconomic reform.
- Fiscal policy:
  - Strong commitment to fiscal consolidation; independent OBR created to monitor.
  - Deficit in cyclically adjusted primary balance halved over last two years (from -7.0 per cent of GDP in 2009-10 to -3.4 per cent of GDP in 2011-12).
  - By end-2011/12 almost 40 per cent of annual consolidation planned for the 2010 Spending Review period achieved.
  - Flexibility allowed pace of structural adjustment to slow in near term; consolidation period extended by two years (2015-16 and 2016-17).
  - Around 80 per cent of total consolidation in 2016-17 will be delivered by lower spending.
  - Programme of over 250 reforms and infrastructure investments includes plans to cut the main rate of corporation tax by six per cent; save businesses over £3 billion through deregulation; invest over £1billion in road infrastructure; and create 450,000 apprenticeships.
- Monetary policy:
  - MPC increased asset purchases by £50 billion to total of £375 billion.
  - MPC continues to view asset purchases as effective; judged further rate cuts could be counterproductive given impacts on lenders’ margins and money-market functioning; Bank Rate maintained at 0.5 per cent but position kept under review.
- Credit easing and liquidity schemes:
  - National Loans Guarantee Scheme: aims to provide £20 billion of government guarantees over two years to enable banks to attract funding at more favourable rates for SMEs.
  - ECTR (Extended Collateral Term Repo Facility) to address short-term sterling liquidity shortages; ECTR operational.
  - Funding for Lending (FLS) scheme details being finalized (see FLS terms above).
- Financial sector reforms and supervision:
  - Interim Financial Policy Committee (FPC) recommended FSA encourage banks to build capital buffers and clarify use of regulatory liquid asset buffers in stress.
  - FPC recommended FSA review liquidity guidance considering Bank of England liquidity insurance availability.
  - Financial Services Bill introduced January 2012; expected to come into force in early 2013. FSA trial running new PRA and FCA structures within existing system.
  - PRA objective: promote safety and soundness of regulated firms; additional objective of policyholder protection for insurers.
  - FCA objective: make markets function well, including responsibility to protect and enhance soundness, stability and resilience of financial system.
  - FPC to be given a secondary objective to support the Government’s economic policy.
  - White Paper to implement Independent Commission on Banking recommendations: proposals for ring-fencing retail deposits and an additional 3 per cent of equity in addition to Basel III minimum standards for largest UK ring-fenced banks; support for binding 3 per cent minimum leverage ratio for all banks.

*Source: Box 2.2 of the October 2008 Global Financial Stability Report; 2012 Article IV Report—Supplementary Information: United Kingdom; Public Information Notice No. 12/81 (July 19, 2012).*

### conclusion that these plans will help limit the frequency and severity of banking crises and

### _cr12190 - conclusion that these plans will help limit the frequency and severity of banking crises and

### Resilience and crisis frequency
- Conclusion that these plans will help limit the frequency and severity of banking crises and strengthen the resilience of the UK financial system.
- Domestic financial sector reform needs to be complemented by a stronger EU and international regulatory and supervisory framework.

### Disclosure and market discipline
- Improving the disclosure of financial sector data to enhance market discipline continues to be a priority for my authorities.
- The PRA intends to publish some regulatory returns and this will be developed in earnest with the implementation of harmonized reporting under CRDIV in the EU.
- The FPC has recognised the potential role of disclosure in fostering financial stability and outlined when it will intervene on specific disclosure and transparency issues.
- The FPC recommended that UK banks work with the FSA and the British Bankers’ Association to ensure greater consistency and comparability of existing Basel II Pillar 3 (Market Discipline) disclosures, beginning with the accounts for the current year.

### International collaboration and commitments
- I welcome staff’s call for international collaboration and continued UK leadership.
- The UK remains fully committed to the global reform agenda, including the full and faithful implementation of the agreed Basel III standards.

*Source: _cr12190 - conclusion that these plans will help limit the frequency and severity of banking crises and*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12190.pdf_