## _cr14233 ## Source details **Canonical URL:** [_cr14233](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14233.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14233.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14233.pdf.json) --- ### Monetary Policy Communications - Focus of the consultation: - Evaluate policies to counter risks to the UK economy and secure durable and robust growth. - Key areas: normalization of monetary policy; financial stability measures; pace and composition of fiscal adjustment; steps to boost housing supply and long-run potential growth. - Recent alignment with Fund advice: - Bank of England maintained an accommodative stance. - Repair of bank balance sheets progressed; strategy for two state-owned banks to return to good health and private ownership elaborated. - Bank of England outlined a stress-testing framework. - Government boosted capital spending within a medium-term fiscal consolidation strategy. ### Recent macroeconomic developments - Growth and demand: - Real GDP: 2012 = 0.3 percent; 2013 = 1.7 percent (nearly twice the 2013 Article IV staff projection of 0.9 percent). - Recovery accelerated since H2 2013 and is becoming more balanced: initial private consumption pickup followed by business investment pickup; net trade modest in 2013. - Slack and labor market: - Unemployment currently at 6.6 percent. - Staff estimate output gap will narrow to -1.3 percent of potential GDP in 2014 (consistent with authorities). - Several indicators imply spare capacity remains (including substantial involuntary part-time workers). - Productivity: - Productivity growth has yet to recover; weak GDP growth combined with strong employment growth explains poor productivity. - Contributing factors: past credit market problems inhibiting investment; increased labor supply (later retirement). - Inflation and costs: - Headline inflation fell to 1.5 percent after being well above the 2 percent target over the past four years. - Fall driven by end of administered price increases, reduced import price pressures, weak wage and margin growth. - Housing market: - London house prices are now 32 percent above pre-crisis levels. - Household debt stabilized at about 140 percent of households’ gross disposable income. - Some deceleration signs may reflect lenders learning MMR loan approval procedures. - External sector: - Current account deficit rose to 4½ percent of GDP in 2013. - NIIP improved from -15 percent of GDP in 2012 to -2 percent in 2013. - Staff estimate current account is 2.6 percent weaker than equilibrium and real exchange rate overvalued by about 5–10 percent. - Real exchange rate depreciated by 23 percent in 2007–09 then gradually appreciated; appreciation accelerated from mid-2013. - Political calendar: - UK general election scheduled for May 7, 2015. - Scotland independence referendum set for September 18, 2014. ### Outlook and risks - Growth and inflation projections (staff): - Real GDP projected: 2014 = 3.2 percent; 2015 = 2.7 percent; medium-term return to trend. - Output gap expected to close gradually; unemployment projected to reach a natural rate of 5.5 percent by 2019. - Projections assume slow recovery in labor productivity to average levels. - Principal risks and channels: - Productivity uncertainty: protracted stagnation (medium likelihood; high impact) could stall recovery; faster productivity growth would spur investment. - Inflation risk if earnings outpace productivity. - Housing-market domestic risks: currently few signs of credit-led bubble, but rising high loan-to-income mortgages increase household vulnerability. - Bank of England estimate: a 2.5 percentage point hike in interest rates would increase average mortgage repayment from 21 to 28 percent of gross disposable income. - External downside risks: withdrawal of unconventional US monetary policies, euro area or emerging market slowdowns, geopolitical tensions. - Financial stability: two global-systemic UK banks (HSBC and Standard Chartered) have large exposures to China and Asia. ### Monetary policy stance, tools, and guidance - Current stance and tools: - Bank rate maintained at 0.5 percent since April 2009. - QE balances: stock of £375bn of gilts on Asset Purchase Facility since October 2012. - Funding for Lending Scheme (FLS) introduced in 2012; lenders have drawn £43.3 billion from FLS; marginal wholesale funding costs fell around 150–200 basis points. - Forward guidance implemented August 2013; originally conditioned on unemployment falling to 7 percent plus other conditions; in February 2014 the unemployment threshold was de-emphasized and guidance shifted to communicate a likely gradual path for Bank rate to eliminate slack over 2–3 years and keep inflation at target. - Financial conditions and credit flows: - Spreads compressed, especially for secured lending and consumer credit. - Consumer credit growth around 5 percent year-on-year in 2013 and continued. - Net secured lending growth around 1 percent year-on-year; gross lending and repayments picked up. - Net lending to businesses over the year remains negative but rate of decline slowed. - Policy guidance and sequencing recommendations: - Monetary policy should stay accommodative for now given contained cost pressures and excess supply. - Policy may need rapid tightening if costs run ahead of productivity or slack is absorbed; consider tightening if financial stability concerns persist. - Macroeconomic arguments favor raising Bank rate before reducing QE balances when normalizing: - Raising policy rate first allows fine-tuning with familiar tools. - Operational imperatives (uncertainty about equilibrium demand for reserves due to new liquidity requirements) may warrant issuing or draining reserves while starting to increase Bank rate. - QE operation indemnified by HMT; OBR projects BoE cash flow losses from 2017/18 onward and HMT transfers may be required. ### Box 1 — Forward guidance and communications (summary) - Context: - Forward guidance introduced August 2013 to improve transparency about MPC reaction function; communication challenge to avoid spurious certainty. - Effectiveness: - Introduction associated with confusion; many interpreted as commitment to “lower-for-longer”. - Forward guidance did not prevent UK yields rising with US yields during Fed “taper” expectations. - Implied volatilities indicate uncertainty about future rates fell after introduction, but caveats apply (broad decline in implied vols across asset classes). - Yield correlations increased and exchange rate appreciated during taper talk period. - Communication options and limits: - Options to enhance clarity: show MPC’s preferred path for interest rates; indicate uncertainty with a fan chart; show individual MPC member placements relative to a median path. - Limits: no guarantee any exogenous interest rate path is intertemporally consistent; full transparency would require target criteria and discussion of variables beyond inflation. - International precedents: Czech Republic, Norway, Sweden, and New Zealand show interest rate projections; first three also show fan charts. - Operational framework and renormalization: - QE-era “floor system” moderates reserves; Bank should announce new monetary control framework and transition plan soon to reduce volatility risk when normalizing. - Communication strategy recommendations: - Continue to signal forthcoming normalization while avoiding spurious precision on timing or size. - Reduce risk that borrowers/lenders assume indefinite accommodation. - Explain coordination of monetary and macroprudential policies given FPC’s role. ### Financial sector policies, supervision, and stress testing - Capital, provisioning, liquidity: - Post-2013 capital-building exercise: major banks’ common equity tier 1 ratios (fully-loaded Basel-III basis) above 9 percent. - Provisioning for future loan losses and conduct-related costs strengthened. - Liquidity indicators improved; wholesale funding reduced. - Faster balance sheet repair correlated with lower borrowing costs, rising equity valuations, eased credit conditions, resuming loan growth. - Financial soundness indicators (simple average for Barclays, HSBC, LBG and RBS) — percent (Basel-II basis): - Total capital ratio: 16.2 18.8 2.5 - Tier 1 ratio: 13.2 14.5 1.3 - Tangible common equity ratio: 4.1 4.5 0.3 - Leverage ratio: 4.6 4.8 0.2 - Provision for loan loss / total loans: 0.9 0.9 0.0 - Reserves for loan loss (% of non-performing assets): 39.4 49.3 9.9 - Non-performing assets / total loans: 6.8 5.6 -1.2 - Loan growth (including to banks): -2.1 -2.7 -0.6 - Net interest income / avg. earning assets: 1.40 1.39 -0.01 - Efficiency ratio (overheads/revenue): 60.6 65.0 4.4 - Return on assets: -0.02 -0.06 -0.04 - Return on common equity: -1.2 -1.6 -0.4 - Trading income (% of total revenue): 8.4 15.0 6.5 - Total loans to total deposits: 104.2 98.1 -6.1 - Wholesale funding / total liabilities: 59.3 53.5 -5.9 - ST borrowings / total liabilities: 5.9 5.4 -0.5 - Liquid assets / total assets: 16.3 16.4 0.1 - Medium-term challenges: - Further capital effort likely needed; some UK banks still lag most European peers. - Building internal equity hampered by conduct-related costs, weak investment banking returns, and costly restructuring. - Increased exposures to housing market: share of residential mortgages in earning assets among five major lenders rose by ~4 percentage points. - Stress test scenarios: EBA common adverse (rise in bond yields and reversal in risk assessment) and BoE UK-specific (negative productivity surprise, snapback in policy rate, 35 percent fall in house prices). - Government-intervened banks: - RBS: internal bad bank strategy and refocusing on UK retail/corporate activity; execution risks noted. - LBG: government sold one third of shareholding (now below 25 percent); rising exposure to housing market a risk. - Regulatory policy and stress testing: - Recommendation to use risk-weighted capital, leverage ratio, and stress testing; utilize CRR/CRDIV flexibility for Pillar-II and countercyclical buffers; introduce leverage ratio above Basel minima. - 2014 concurrent stress tests to assess eight major UK banks; success depends on coordination, clear communication of capital definitions and hurdle rates, and disaggregated disclosure. - Broaden stress-test perimeter and strengthen supervision beyond major banks; prioritize monitoring shadow banking risks. - Structural reforms and market integrity: - New regulatory architecture (FPC, PRA, FCA) functioning relatively smoothly; maintain coordination and coherent communication. - Sterling Monetary Framework reforms: strengthen liquidity backstops, but guard against increasing risk appetite; ensure BRRD does not inhibit emergency liquidity support. - Too-Important-To-Fail measures: progress on ring-fencing, bail-in and resolution powers; outstanding tasks include strategies for entities outside the ring fence and international agreements on gone-concern loss-absorbing capacity. - Conduct reforms: legal regime to hold senior managers accountable extended; “Fair and Effective Markets Review” to strengthen governance and oversight of wholesale markets and extend regulatory perimeter where needed. ### Macroprudential policy and housing-market response - Macroprudential consensus: - Macroprudential policies agreed as first response to housing-market risks. - MMR and lenders’ tighter lending standards expected to limit risks. - FPC recommended higher interest-rate stress tests (increase in Bank rate of 3 percentage points) in MMR affordability assessments and limits on share of new lending at high loan-to-income multiples. - Early and gradual use of tools advised; public and institutional understanding important for active use. - Housing supply and Help to Buy: - Supply picked up but remains below required levels. - Planning reform progress needed; no current plans for property tax reform. - Help to Buy increased construction; mortgage guarantee transactions so far not a significant driver of house prices. - FPC post-mission recommendations: - Test mortgage affordability against a Bank Rate 3 percent higher than at origination. - No more than 15 percent of a lender’s flow of new mortgages should be at or above four-and-a-half times income. - LTI limit not expected to bind market as a whole if economy follows Bank’s central forecasts. ### Fiscal framework, policy stance, and structural reforms - Fiscal framework review: - Current objectives: (i) balance structural current budget by rolling 5-year period; (ii) put net debt-to-GDP on a downward path by FY2015/16. - First objective expected to be met in a few years; latter will be redundant soon. - Need new framework with operating targets directly controllable by policymakers, closely linked to debt sustainability (e.g., overall deficits) and flexible for shocks. - Formalization of the Spending Review process could reduce medium-term expenditure uncertainty. - Fiscal outlook and composition: - Public sector overall balance (percent of GDP): 2012 = -6.9; 2013 = -5.8; 2014 (Proj.) = -4.8; 2015 (Proj.) = -3.6. - General government gross debt (percent of GDP): 2012 = 88.5; 2013 = 91.2; 2014 (Proj.) = 92.1; 2015 (Proj.) = 93.0. - Public sector net debt (percent of GDP): 2012 = 74.2; 2013 = 75.8; 2014 (Proj.) = 77.9; 2015 (Proj.) = 79.1. - Deficit nearly halved but pace slower than original plan; consolidation mainly driven by expenditure measures. - Government envisages balancing budget by FY2018. - Structural priorities to boost potential growth: - Infrastructure: road congestion high in EU; 20 percent of electricity generating capacity expected to close within next decade; recommend expanded public investment and guarantee schemes. - Education: UK leads OECD in tertiary attainment but only 78 percent enrolment for population aged 15–19; recommend expand vocational training and apprenticeships to reduce double-digit youth unemployment. - Immigration: restrictive policies could harm productivity; recommend relax requirements in labor-short areas and loosen student visas. ### External sector assessment (Annex 1) - Overall assessment: - NIIP improved from -15 percent of GDP in 2012 to -2 percent in 2013. - Gross positions ~600 percent of GDP. - Staff project NIIP to decline to about -8 percent by 2019. - External position moderately weaker than implied by fundamentals and desirable policy settings; external deficits reflect insufficient public and private saving and lack of competitiveness and export diversification. - Current account and real exchange rate: - EBA CA regression: CA gap around -2.6 percent of GDP. - Staff assess 2013 REER as 5–10 percent above level consistent with fundamentals; EBA REER regression suggests 10–15 percent overvaluation but approaches differ. - Capital and financial accounts: - Portfolio investment and financial derivatives are key financial account components; large fluctuations in capital flows are inherent and a source of vulnerability. - Reserves and intervention: - Reserves low by standard metrics: 4 percent of GDP end-2013; currency is free floating. - Policy responses: - Rebalance toward private-sector-led demand and greater reliance on external demand; structural reforms to broaden skills and invest in infrastructure to boost competitiveness. ### Risk Assessment Matrix — selected entries and staff recommendations - Definitions: - “low” = probability below 10 percent; “medium” = 10–30 percent; “high” = 30–50 percent. - High-likelihood risks: - Surges in global financial market volatility (High likelihood; High impact). - Triggers include geopolitical tensions and UMP exit/repricing. - Staff recommendations: continue accommodative monetary policy; consider backstops for systemic non-banks and enhanced regulation/supervision; use enhanced liquidity facilities for banks. - Protracted slower growth (High likelihood; Medium impact). - Staff recommendations: continue accommodative monetary policy; move to neutral fiscal stance; implement structural policies to boost investment, productivity, and competitiveness. - Medium-likelihood risk: - Growth slowdown in China (Medium likelihood; Medium impact). - Impact through financial linkages via G-SIBs (HSBC and Standard Chartered); limited trade exposure (3 percent of exports to China). - Staff macro projections (selected headline figures): - Real GDP: 2012 = 0.3; 2013 = 1.7; 2014 (Proj.) = 3.2; 2015 (Proj.) = 2.7. - CPI, end-period: 2012 = 2.6; 2013 = 2.1; 2014 (Proj.) = 1.9; 2015 (Proj.) = 2.0. - Unemployment rate (period average): 2014 (Proj.) = 6.5; 2015 (Proj.) = 6.3; 2019 (Proj.) = 5.5. - Current account (percent of GDP): 2012 = -3.8; 2013 = -4.4; 2014 (Proj.) = -4.0; 2015 (Proj.) = -3.5; 2019 (Proj.) = -1.2. ### Executive Board assessment and guidance (summary) - Overall view: - Directors welcomed rebound in output and employment; considered overall policy mix appropriate given remaining slack and weak external environment. - Fiscal policy: - Supported near-term consolidation while avoiding undermining growth; urged continuation of medium-term consolidation to put debt on downward path; encouraged both revenue and expenditure measures with attention to efficiency and equity. - Monetary policy and communications: - Maintaining accommodative stance appropriate near-term; noted BoE’s intention to raise policy rate first when normalizing but stressed sequencing flexibility and clear communications from MPC and FPC. - Macroprudential and financial stability: - Macroprudential measures first line of defense against housing risks; encouraged readiness to adjust limits, modify Help to Buy, or take new steps if vulnerabilities escalate. - Noted BoE may need to raise interest rates if macroprudential tools prove insufficient. - Recommended supply-side measures for housing (eliminate unnecessary development restrictions and reform property taxation), continue bank capital strengthening, address misconduct, monitor shadow banking, and maintain international consistency in reforms. - Structural reforms: - Priority areas: infrastructure (transportation and energy), education and training, immigration, and financial intermediation. ### Selected quantitative tables and indicators (selected reported values retained exactly) - Macro outlook (selected series — Table 2): - Real GDP (Proj.): 2014 = 3.2; 2015 = 2.7; 2016 = 2.5; 2017 = 2.4; 2018 = 2.4; 2019 = 2.4. - CPI Inflation, end period (Proj.): 2014 = 1.9; 2015 = 2.0; 2016 = 2.0; 2017 = 2.0; 2018 = 2.0; 2019 = 2.0. - Output gap (percent of potential): 2014 = -1.3; 2015 = -0.6; 2016 = -0.3; 2017 = -0.1; 2018 = 0.0; 2019 = 0.0. - Unemployment rate (period average): 2014 = 6.5; 2015 = 6.3; 2016 = 5.9; 2017 = 5.7; 2018 = 5.6; 2019 = 5.5. - Current account (percent of GDP): 2014 = -4.0; 2015 = -3.5; 2016 = -3.1; 2017 = -2.5; 2018 = -1.9; 2019 = -1.2. - Public finance (selected staff projections and reported values): - Public sector overall balance (percent of GDP): 2012 = -6.9; 2013 = -5.8; 2014 (Proj.) = -4.8; 2015 (Proj.) = -3.6. - Public sector net debt (percent of GDP): 2012 = 74.2; 2013 = 75.8; 2014 (Proj.) = 77.9; 2015 (Proj.) = 79.1. - Net lending/borrowing (overall balance, percent of GDP) — FY series: FY2010 = -9.3; FY2011 = -7.6; FY2012 = -6.9; FY2013 = -5.8; FY2014 = -4.9; FY2015 = -3.8; FY2016 = -2.2; FY2017 = -0.9; FY2018 = 0.1. - Housing market (selected observations and indicators): - UK house prices increased by 10.5 percent in the year to May 2014. - House prices excluding London and the South East increased by 6.4 percent in the year to May 2014. - House prices in real terms remain around 5 percent lower than in 2007. - Average gross debt-servicing ratio on new mortgage lending: less than 19 percent of borrowers’ incomes in recent quarters. - In the four quarters to 2014 Q1, around 10 percent of lending for house purchase was at an LTI at/above four-and-a-half times income (compared to 6.5 percent in 2005–07). - Mortgage approvals fell for the third consecutive month in April and were 17 percent below the January 2014 peak. - External/current account numbers: - Current account (percent of GDP): 2012 = -3.8; 2013 = -4.4; 2014 (Proj.) = -4.0; 2015 (Proj.) = -3.5. - Trade in goods (2014 Proj., percent of GDP): exports = 17.4; imports = -23.8. - Trade in services (2014 Proj., percent of GDP): exports = 12.1; imports = -7.1. - Income balance (percent of GDP): 2014 (Proj.) = -1.0; 2015 (Proj.) = -0.6; 2016 (Proj.) = -0.2; 2017 (Proj.) = 0.0; 2018 (Proj.) = 0.4; 2019 (Proj.) = 1.0. *International Monetary Fund — Selected chapter content.* ### 1. Monetary Policy Communications _____________________________________________________________ 10 ### 1. Monetary Policy Communications ### Focus of the Consultation - Evaluate policies to counter risks to the UK economy and secure durable and robust growth. - Key areas of assessment: - Normalization of monetary policy. - Measures to address financial stability risks and ensure a vibrant, but safe financial sector. - Pace and composition of fiscal adjustment. - Steps to boost housing supply and long-run potential growth. - Recent policy alignment with Fund advice: - Bank of England has maintained an accommodative monetary policy stance. - Repair of bank balance sheets has progressed; authorities elaborated a strategy for two state-owned banks to return them to good health and eventually private ownership. - Bank of England outlined a framework for stress-testing bank soundness. - Government has boosted capital spending within a medium-term fiscal consolidation strategy. ### Recent Developments - Growth and demand: - After expanding by just 0.3 percent in 2012, real GDP grew by 1.7 percent in 2013 (nearly twice the projection in the 2013 Article IV Staff Report, which projected 0.9 percent). - Recovery accelerated since the second half of 2013 and leading indicators suggest momentum. - Recovery becoming more balanced: initial private consumption pickup (decline in household saving rates), followed by business investment pickup; net trade made only a modest contribution in 2013. - Slack and labor market: - Unemployment is currently at 6.6 percent. - Staff estimates that the output gap will narrow to 1.3 percent of potential GDP in 2014 (consistent with authorities’ estimates). - Several indicators suggest spare capacity remains (including substantial numbers of involuntarily part-time workers). - Productivity: - Productivity growth has yet to recover; weak GDP growth combined with strong employment growth explains poor productivity performance. - Factors cited: past credit market problems inhibiting investment to more productive sectors; increase in labor supply (shift towards later retirement) enabling substitution toward labor. - Inflation and costs: - Headline inflation has fallen to 1.5 percent after being well above the 2 percent target over the past four years. - Fall driven by end of administered price increases, reduced import price pressures, and weak growth in wages and margins despite strong employment and output growth. - Housing market: - House prices rising rapidly and over an increasingly wide area; in London levels are now 32 percent above those before the crisis. - Price:income multiples and loan:income multiples are increasing. - Interest servicing costs remain at historic lows. - Household debt has stabilized at about 140 percent of households’ gross disposable income. - Some signs of deceleration in house prices may reflect temporary effects from lenders learning new loan approval procedures under the Mortgage Market Review (MMR). - External sector: - Current account deficit rose to 4½ percent of GDP in 2013, due to a large decline in the income balance and lackluster export growth. - Net international investment position (NIIP) improved from -15 percent of GDP in 2012 to -2 percent in 2013. - Staff estimate that the current account balance is 2.6 percent weaker than its equilibrium level, and that the real exchange rate is overvalued by about 5–10 percent. - Real exchange rate depreciated by 23 percent in 2007–09 then gradually appreciated; appreciation accelerated from mid-2013. - Political calendar and contingencies: - UK general election scheduled for May 7, 2015. - Scotland referendum on independence set for September 18, 2014; ballot question: “Should Scotland be an independent country?” - A “yes” vote would raise issues about allocation of assets and liabilities, exchange rate regime, regulatory framework, and international institution membership. ### Outlook and Risks - Growth and inflation projections: - Real GDP projected to expand by 3.2 percent in 2014 and 2.7 percent in 2015, before gradually returning to trend rates. - Projections assume a slow recovery in labor productivity growth to average levels. - Output gap expected to close gradually; unemployment projected to reach a natural rate of 5.5 percent by 2019. - Risks: - Productivity uncertainty implies both upside and downside scenarios: faster productivity growth would spur investment and output; persistently flat productivity could stall the recovery as spare capacity is exhausted. - If earnings claims outpace productivity, inflation risks could accelerate. - Housing market creates domestic risks: currently few signs of a credit-led bubble (modest net credit growth, relatively low transaction churn, households not drawing on housing equity), but increasing prevalence of high loan-to-income mortgages raises household vulnerability to income and interest rate shocks. - Bank of England estimate: a hike in interest rates of 2.5 percentage points would increase the average mortgage repayment (principal plus interest rate payments) from 21 to 28 percent of gross disposable income. - External downside risks: withdrawal of unconventional US monetary policies, sharp euro area or emerging market slowdowns, increases in geopolitical tensions. - Presence of two globally-systemic UK banks (HSBC and Standard Chartered) with large exposures to China and Asia implies potential financial stability risks from a sharp China slowdown. ### Monetary Policy - Current stance and tools: - Monetary policy has been highly accommodative. - Bank rate has been maintained at 0.5 percent since April 2009. - QE balances: Bank has kept a stock of £375bn of gilts on the books of the Asset Purchase Facility since October 2012. - Funding for Lending Scheme (FLS) introduced in 2012; since inception lenders have drawn £43.3 billion from the FLS; marginal wholesale funding costs have fallen around 150–200 basis points. - In August 2013, Bank of England formally implemented “forward guidance” similar to the Federal Reserve’s. - Original policy: hold policy rates fixed and the stock of assets purchased not reduced at least until the unemployment rate had fallen to 7 percent, subject to conditions on projected CPI inflation, medium-term inflation expectations, and absence of substantial financial stability threats. - In February 2014 the unemployment threshold was de-emphasized; Bank now communicates that the appropriate path for Bank rate to eliminate slack over the next 2-3 years and keep inflation at target would likely be gradual. - Financial conditions and credit flows: - Spreads over funding rates have compressed, especially for secured lending and consumer credit. - Consumer credit rebounded strongly in 2013 and has continued to grow at rates of around 5 percent, year-on-year. - Growth of net secured lending around 1 percent, year-on-year; gross lending and repayments have picked up strongly. - Net lending to businesses over the year remains negative but the rate of decline has slowed and shows signs of stabilizing. - Policy guidance and recommendations: - Monetary policy should stay accommodative—for now, given contained cost pressures and remaining excess supply. - Policy might have to be tightened quickly if costs run ahead of productivity growth or slack is absorbed, and should be considered if financial stability concerns cannot otherwise be addressed. - Macroeconomic arguments favor raising Bank rate before reducing QE balances when normalizing conditions: - Raising the policy rate first is preferable for fine-tuning tightening using familiar tools. - Operational imperatives may warrant a more flexible sequencing: uncertainty about equilibrium demand for central bank reserves due to new regulatory liquidity requirements may imply the need to drain some central bank reserves when renormalizing (for example, issuing while starting to increase Bank rate). - Note on QE and fiscal interaction: QE operation is fully indemnified by HMT; asset purchase gains/losses affect HMT transfers. Based on market expectations, OBR projects BoE would incur cash flow losses from 2017/18 onward and HMT would need to transfer cash to BoE to cover these losses. *Italic: International Monetary Fund — Selected chapter content.* ### Box 1. Monetary Policy Communications ### Box 1. Monetary Policy Communications ### Context and objectives - The Bank of England implemented “forward guidance” with formal introduction in August 2013. - Purpose as characterized by MPC members: to improve transparency about the Bank’s reaction function. - Communication challenge ahead: reduce risks of adverse effects from surprises about changes in policy settings, yet not feed spurious certainty about future interest rates. ### Effectiveness of forward guidance - Market and commentator reaction: - Introduction in August 2013 was associated with some confusion about its purpose; many interpreted it as a commitment to “lower-for-longer” interest rates. - Because forward guidance did not prevent UK yields rising with US yields as expectations of Fed “tapering” increased (even at short maturities), some concluded forward guidance had failed. - In February 2014, the unemployment threshold was de-emphasized, causing some to question whether the policy was still active. - Evidence on uncertainty: - Data on implied volatilities indicate that uncertainty about future rates did indeed fall after introduction of forward guidance. - Caveat: implied vols of many asset classes have been falling steadily since the implementation of unconventional monetary policies; the observed decline might be a reversion to trend after the exceptional period from the first “taper talk” in May to the “no taper” announcement in September, rather than an effect of forward guidance. - Market co-movements and exchange rate: - Yield correlations increased compared with those before taper talk; the exchange rate appreciated during this period rather than acting as a buffer. - One possibility is positive news about the UK economy, but that cannot completely account for the degree of comovement at daily frequencies. ### Other communication tools and transparency options - Current Bank communications: - Speeches by MPC members have tried to alert markets to future interest rate increases. - The Inflation Report is now more explicit about key judgments and risks to projections. - The Report currently stops short of showing what the MPC believes should happen to interest rates—the forecast is “conditioned” on market expectations. - Options to enhance clarity: - Forecasts could be based on the MPC’s preferred path for interest rates, removing a step markets have to take to deduce the MPC’s thinking. - Uncertainty around the interest rate path could be indicated by a fan chart, analogous to current GDP and inflation forecasts, to signal that the path is a projection rather than a promise. - Showing how individual MPC members place themselves relative to a “median” path could indicate internal dispersion if members argue a given interest rate path is not their preference. - Limits to transparency: - No guarantee that any exogenous interest rate path—whether from the market or an MPC member’s preferred reaction—is intertemporally consistent. - Intertemporal consistency would require employing “target criteria” and openly discussing these criteria with the public; this would likely necessitate clear statements about how variables other than inflation, including financial market variables, affected judgments about desired interest rates. - Few institutions have shown a willingness to be so transparent; moving in that direction would require careful thought about interactions with FPC decisions. - International precedents: - Interest rate projections have been shown for some years by the central banks of the Czech Republic, Norway, Sweden, and New Zealand; the first three also show fan charts. ### Operational framework and normalization - Transition from QE-era framework: - At the start of QE, the Bank moved away from its reserve averaging-cum-“corridor system” for Bank rate targeting to the current “floor system” in which reserves are remunerated at the Bank rate. - Need for clarity: - With prospects of a rate rise strengthening, the Bank will need to announce soon what the new monetary control framework will be and how the transition to it will be managed. - An early pronouncement will enable banks to plan accordingly and help reduce the possibility of a sudden surge in the volatility of short-term rates during renormalization after a long period of very low volatility. ### Communication strategy recommendations - Continue to point to a forthcoming normalization of monetary policy, while avoiding spurious precision about timing or size of moves. - Reduce the risk that borrowers and lenders assume monetary conditions will remain accommodative indefinitely, given: - Policy rates have been so low for so long. - Retail spreads have compressed further since the market stresses in 2012. - Explain coordination of monetary and macroprudential policies, because: - The Financial Policy Committee (FPC) now plays a key role in affecting economic conditions. - Macroprudential measures will have implications for the pace of economic activity and changes in interest rates will affect prudential risks. *Source: Box 1. Monetary Policy Communications, UNITED KINGDOM — INTERNATIONAL MONETARY FUND* ### 30. The planned review of the fiscal framework is opportune. Fiscal policy is currently ### _cr14233 - 30. The planned review of the fiscal framework is opportune. Fiscal policy is currently ### Fiscal framework review - Current objectives: - (i) balancing the structural current budget by the end of a rolling 5-year period; - (ii) putting the net debt-to-GDP ratio on a downward path by FY2015/16. - Status and implications: - The first objective is expected to be met within a few years, and the latter will be redundant soon. - A new framework is needed with clearly defined operating targets that: - can be directly controlled by policymakers; - are closely linked to debt and its sustainability (such as overall deficits); - allow flexibility to deal with unexpected shocks. - Suggested procedural reform: - Formalization of the Spending Review process could help reduce uncertainty about the medium-term expenditure framework. ### Financial sector policies — Capital, provisioning, and liquidity - Recent progress: - Following the Bank of England’s 2013 capital-building exercise, major UK banks’ common equity tier 1 ratios (on a fully-loaded Basel-III basis) have risen above 9 percent. - Provisioning for future loan losses and conduct-related costs has strengthened. - Capital build was largely driven by new capital issuance and non-core deleveraging. - Liquidity indicators have improved, with a further reduction in wholesale funding. - Faster balance sheet repair has been associated with a fall in banks’ borrowing costs to historic lows, rising equity valuations, eased credit conditions, and resuming loan growth. - Financial soundness indicators (simple average for Barclays, HSBC, LBG and RBS) — percent (reported on a Basel-II basis): - Total capital ratio16.218.82.5 - Tier 1 ratio13.214.51.3 - Tangible common equity ratio4.14.50.3 - Leverage ratio4.64.80.2 - Provision for loan loss / total loans0.90.90.0 - Reserves for loan loss (% of non-performing assets)39.449.39.9 - Non-performing assets / total loans6.85.6-1.2 - Loan growth (including to banks)-2.1-2.7-0.6 - Net interest income / avg. earning assets1.401.39-0.01 - Efficiency ratio (overheads/revenue)60.665.04.4 - Return on assets-0.02-0.06-0.04 - Return on common equity-1.2-1.6-0.4 - Trading income (% of total revenue)8.415.06.5 - Total loans to total deposits104.298.1-6.1 - Wholesale funding / total liabilities59.353.5-5.9 - ST borrowings / total liabilities5.95.4-0.5 - Liquid assets / total assets16.316.40.1 ### Medium-term challenges and emerging risks - Capital needs and profitability headwinds: - Further capital effort likely needed over the medium-term. - Some major UK banks’ capital positions still fall short of most European peers’. - Building internal equity will be challenging because of: - a longer- and larger-than-expected drag from conduct-related costs; - a weak outlook for investment banking returns; - the need in some cases to undertake or complete costly business restructuring. - Emerging risk exposures: - Banks’ exposures to the housing market increased over the last two years: the share of residential mortgages in earning assets among the five major lenders rose by an average of almost 4 percentage points. - Other risks: HSBC and Standard Chartered exposure to a China slowdown; indirect spillovers from a potential geopolitical crisis involving Russia (direct exposures are small). - Concern over a disorderly correction in markets’ pricing of risk that could entail losses for globally-connected UK-resident banks and dealers. - Specific data points and scenarios: - EBA common adverse scenario includes a rise in bond yields and reversal in risk assessment, especially toward emerging markets. - Bank of England UK-specific scenario combines a negative productivity surprise, a snapback in the policy rate, and a 35 percent fall in house prices. ### Government-intervened banks - RBS: - Returning RBS to profitability has been difficult due partly to its complex business model and outsized operating costs. - New strategy: an internal bad bank and refocusing a more efficient core bank on UK retail and corporate activity — appropriate but with execution risks. - LBG: - Strong performance has enabled the government to sell one third of its shareholding (now below 25 percent) over the past year. - Large and rising exposure to the UK housing market remains a source of risk. ### Regulatory policy, stress testing, and supervision - Regulatory framework: - Authorities are seeking a capital framework based on risk-weighted capital, the leverage ratio, and stress testing. - Recommendation to fully utilize flexibility under CRR/CRDIV regarding Pillar-II and countercyclical buffers and to introduce a leverage ratio requirement above Basel minima. - Importance of clear and early communication of regulatory expectations to alleviate uncertainty. - 2014 concurrent stress tests (coordinated with EBA): - Will assess the ability of the eight major UK banks to withstand large shocks. - Complementary scenarios: EBA’s common adverse scenario and the Bank’s UK-specific scenario. - Success depends on coordination between macro- and micro-prudential authorities; clear communication about capital definitions, hurdle rates, and required capital actions; and sufficiently-disaggregated disclosure of results. - Any required capital actions (especially for the two international banks) should be informed by sequential PRA stress tests assessing resilience to a sharp China slowdown. - Broader coverage and shadow banking: - Important to broaden stress-test institutional perimeter and strengthen supervision beyond major banks. - Medium-term plans could extend concurrent stress testing to systemic entities beyond major UK banks. - Efforts to strengthen monitoring of risks in the shadow banking system are critical, given: - the size of shadow banking activity routed through the UK; - evidence of search-for-yield and leverage build-up outside the banking system; - the associated risk of outward financial spillovers in the event of an abrupt change in risk sentiment. - Any additional budgetary resources, regulatory perimeter adjustments, and international coordination initiatives related to “global” shadow banking should be prioritized. ### Structural financial reforms and market integrity - New regulatory architecture: - The FPC, PRA and FCA structure has functioned relatively smoothly over the last year and is helping deliver a more resilient financial system. - Maintaining strong coordination across bodies and coherent communication is vital to avoid uncertainty. - For the Bank of England, maintain and further develop effective internal and external oversight arrangements given its expanded mandate. - Sterling Monetary Framework reforms: - Strengthened liquidity backstops should help solvent UK banks ride out temporary funding stresses. - Easier access to backstops could increase banks’ appetite for risk-taking unless supervision is commensurately strengthened. - Implementation of backstops to major broker-dealers and central counterparties should be guided by this consideration. - Need to ensure the EU Bank Recovery and Resolution Directive (BRRD) does not inhibit the Bank’s ability to extend emergency liquidity support. - Too-Important-To-Fail (TITF) measures: - Progress: ring-fencing retail operations, new bail-in and resolution powers for the Bank of England, and development of resolution strategies for systemically important banks. - Outstanding tasks: clear strategy for systemic entities outside the ring fence; maintain cross-border cooperation on resolution of global banks, including international agreement on gone-concern loss-absorbing capacity. - Implementation should ensure international consistency and guard against regulatory arbitrage; avoid excessive penalization that stifles market making or migrates risks to non-bank financial institutions. - Conduct, accountability, and market reforms: - New legal regime to hold senior bank managers more directly accountable is being extended to all UK-resident banks and, subject to consultation, branches of foreign banks. - “Fair and Effective Markets Review” aims to: - strengthen governance and oversight of wholesale fixed income, commodity and currency markets; - assess extending the regulatory perimeter for unregulated wholesale markets (such as FX and precious metals) where international coordination may be required; - subject additional benchmarks (other than LIBOR) to recent UK legislation including criminal sanctions for market manipulation. - These measures aim to reform banking culture, ensure market integrity, and strengthen confidence in the UK’s financial center. ### Transparency, tax evasion, and international spillovers - UK efforts to enhance entity transparency and address tax evasion: - Aiming to improve transparency of companies’ and trusts’ ownership in the UK and in British overseas territories (BoTs) and Crown dependencies (CDs). - Mobilizing the anti-money laundering (AML) framework. - Consultation concluded and primary legislation is expected to be introduced in Parliament soon. - Implementation may necessitate economic adjustments, particularly in BoTs and CDs, and could generate spillovers on other financial centers through transmission of UK regulation via global banks located in the UK. - UK authorities indicated they do not play any role in ensuring corporate transparency or enforcing legislation on tax crimes in the BoTs and CDs. ### Supply-side policies to support potential growth - Key structural impediments dampening long-run potential growth: - Infrastructure: - Road congestion in the UK remains among the highest in the EU. - 20 percent of electricity generating capacity is expected to close within the next decade. - Recommendation: further expansion in public investment in infrastructure projects within the medium-term fiscal framework, and implementation of well-designed guarantee schemes. - Education: - UK leads OECD in tertiary educational attainment but lags for population aged 15–19: only 78 percent of this population segment is enrolled in education, below the OECD average. - Recommendation: expand vocational training and apprenticeship programs to provide skills for the young and reduce the double-digit youth unemployment rate. - Immigration: - Restrictive immigration policies could negatively impact productivity growth. - Recommendation: relax immigration requirements in areas with labor shortages (such as manufacturing) and loosen the visa regime for foreign students to expand the skilled labor force and improve prospects of higher education exports. ### Authorities’ views and monetary policy - Authorities’ assessment: - Treasury and Bank of England staff view the recovery as having momentum and becoming more balanced; uncertainty about productivity is high. - Regional differences in house prices noted; no widespread deterioration in lending standards or signs of “bubble”-like behavior so far. - Prospects: strong growth in 2014 reverting to trend, moderate increases in productivity growth, and little contribution from net exports. - Risks identified: domestic (productivity, indebted households’ vulnerability to interest rate and income shocks) and external (financial disruption from US monetary normalization, sharper-than-expected China slowdown, weak demand from key export markets especially the euro area); general concern about under-pricing of risk by markets. - Monetary policy stance: - Viewed as appropriate. - Need for careful communication to ensure public understands MPC will, in time, need to raise rates from current levels. - Normalization should begin with rises in Bank rate and proceed gradually. - The “natural” rate of interest likely to remain below pre-crisis levels. - Asset sales should be considered only once Bank Rate has reached a level from which it could be cut in the face of a negative shock. - The Bank of England’s balance sheet may remain large by historical standards due to increased demand for liquid assets. *Source: _cr14233 - 30. The planned review of the fiscal framework is opportune. Fiscal policy is currently* ### 47. Macroprudential policies were widely agreed to be the first response to risks from the ### _cr14233 - 47. Macroprudential policies were widely agreed to be the first response to risks from the ### Macroprudential policies and housing risks - Macroprudential policies were widely agreed to be the first response to risks from the housing market. - The MMR and lenders’ own tighter lending standards should act to limit some risks. - The FPC recommended: - Mortgage lenders apply more stringent interest rate stress tests (an increase in Bank rate of 3 percentage points) as part of their MMR affordability assessments. - Limit the proportion of new lending at high loan-to-income multiples. - Uncertainty about the effects of such tools implied taking early and gradual steps. - It is important to improve the understanding of the general public and of the other domestic institutions for the active use of macroprudential tools. ### Housing supply, regional disparities, and Help to Buy - Authorities emphasized supply-side constraints and regional disparities behind house prices. - Supply had picked up during the past year in response to policy initiatives, but was well below levels needed to satisfy demand. - Further progress on planning reform was needed and would require broad political consensus. - There are no plans for property tax reform at present. - Help to Buy: - Had brought about some increase in construction. - Transactions so far under the mortgage guarantee part of the scheme were not playing a significant role in rising house prices. ### Fiscal outlook and consolidation - The overall fiscal deficit had come down, but further consolidation efforts would be needed to bring down public debt. - Given national elections in 2015, the details of medium-term consolidation plans have not yet been specified. - Revenue measures had been front loaded; risks to future revenue (especially arising from structural changes to the oil and financial sectors) exist. - Consolidation should seek an appropriate mix between expenditure and revenue measures, ideally including additional gains in expenditure efficiency, with due attention to social equity. - Spending decisions should prioritize efficiency gains and areas of spending that provide value for money, while continuing to provide high quality outputs in key areas including science, infrastructure, education, and health. ### Financial sector health, reforms, and supervisory architecture - Financial policies were seen as successful in bringing banks to better health, but many challenges remained. - Banks had more capital. - Significant progress had been made on the two state-intervened entities, with a complete sale of the government’s stake in LBG feasible over the medium term. - Authorities judge RBS’s recently-announced restructuring strategy to be on course, while acknowledging remaining challenges. - The three-pronged capital framework, including a leverage ratio requirement, was viewed as particularly important. - Authorities emphasized the importance of concurrent stress tests in targeting UK-specific risks and global shocks. - Structural financial reforms effects: - New architecture focuses on coordination and communication to ensure forward-looking, judgment-based supervision. - Introduction of ring fencing and new resolution and bail-in powers for the Bank of England, and development of resolution strategies and plans, is helping to make systemically-important firms more resolvable. - Securing international agreements on GLAC and cross-border enforceability of resolution actions later this year (in line with the FSB’s commitments to the G20 leaders) will also be critical. - Reforms to the Sterling Monetary Framework, with deeper and broader supervision of backstopped entities, would ensure resilience and favorable spillovers. ### Data, measurement, and constraints - Authorities noted the importance of accurate and reliable data in forming an assessment of the economy. - Analysis of some important areas—notably business investment—was constrained by the level of detail available. - National accounts investment and trade data were sometimes at odds with other survey sources, and revisions in recent years had been substantial. - New accounts to meet ESA requirements, forthcoming toward the end of the year, could have potentially significant changes. ### Staff appraisal — growth, inflation, exchange rate, and policy tradeoffs - Rebound in growth is strong and welcome. - Promising signs: growth in business investment now running ahead of private consumption; employment growth has remained strong. - Inflation has been contained, justifying the Bank of England’s stance of “looking through” above-average headline inflation and focusing on underlying pressures. - Public finances improved, albeit somewhat less “tax rich” than might be hoped for based on GDP growth. - Exchange rate: persistent trade deficit suggests an overvaluation in the order of 5–10 percent, though such measures come with a wide range of uncertainty. - Immediate challenge: ensure strong growth persists without creating inflationary pressures or financial stability risks. - Productivity developments are central; even a relatively modest increase in labor productivity would facilitate higher real wages needed to sustain the recovery. - Should productivity fail to pick up, the MPC would eventually have to tighten monetary conditions to dampen inflationary pressures. - Housing market buoyancy creates risks to household finances and affordability; Bank of England has mandate and tools to address such risks and has begun to use them. - Impact of tools will need close monitoring; settings (including coverage) may need modification over time. - Interest rate increases could be considered, should macroprudential tools prove ineffective, with careful consideration of tradeoffs. ### Ongoing financial-sector priorities - Strengthen monitoring of risks in the shadow banking system. - Maintain clear communication and coordination across regulatory bodies. - Ensure effective oversight arrangements at the Bank of England given its expanded mandate. - Authorities remain alert to remaining work on banking culture and Too-Important-To-Fail reforms; implement reforms to ensure international consistency and avoid regulatory arbitrage. ### Fiscal policy stance and medium-term recommendations - Fiscal policy is appropriate for the immediate term. - To put debt on a downward path, more consolidation will be needed over the medium term. - Potential for further revenue gains, notably from eliminating tax expenditures. - Relying entirely on expenditure cuts would likely imply reduced delivery of key public services and/or highly regressive policies. ### Institutional engagements and calendar - It is recommended that the next Article IV consultation with the United Kingdom be held on the standard 12-month cycle. - An FSAP assessment is expected to be conducted in time for 2016 Article IV consultation discussions, in line with the usual five-year cycle for jurisdictions with systemically important financial sectors. ### United Kingdom: Risk Assessment Matrix — key risks and policy recommendations - Risk: Protracted period of stagnant productivity (Likelihood: Medium; Expected impact: High) - Expected impacts: - Increase in unit labor costs. - Loss of competitiveness. - Slowdown of GDP growth. - Policy recommendations: - Accelerate the implementation of productivity-enhancing structural reforms. - Tighten monetary policy if earnings increase ahead of productivity. - Risk: Financial stability risks arising from the housing market (Likelihood: Medium; Expected impact: High) - Expected impacts: - Increase in household debt leverage. - Rapid expansion of mortgage credit growth. - Higher exposure of the financial system to the housing market. - Policy recommendations: - Tighten macroprudential policy by imposing caps on high loan-to-income mortgages. - Tighten underwriting standards. - Tighten parameters of Help-to-Buy by restricting the qualification criteria (i.e., reducing the maximum house price). - Consider raising policy rate (if above measures prove inadequate). - Risk: Bond market stress from a reassessment in sovereign risk in the Euro area (Likelihood: Low; Expected impact: Medium) - Expected impacts: - Tightening financial conditions if funding costs rise for banks with large EA exposures. - Potential safe haven inflows and lower sovereign yields. - Policy recommendations: - Adjust monetary policy, depending on net impact on inflation, asset prices and financial conditions. *Source: _cr14233 - 47. Macroprudential policies were widely agreed to be the first response to risks from the* ### 1. The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely ### _cr14233 - 1. The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff) ### Risk Assessment Matrix (RAM): principal risks, likelihoods, impacts, and staff policy recommendations - Definitions and probabilities: - “low” = probability below 10 percent. - “medium” = probability between 10 and 30 percent. - “high” = probability of 30 and 50 percent. - RAM reflects staff views as of the time of discussions with the authorities; risks are not mutually exclusive and may interact. - High-likelihood risks and channels (staff assessment): - Surges in global financial market volatility (High). - Triggers: geopolitical tensions, revised market expectations on UMP exit/emerging market fundamentals, and general re-pricing of risk. - Impacts (High): tightening of financial conditions and market discontinuity; increased uncertainty could depress investment, consumption, and GDP growth; sharp reduction in house prices and asset prices with implications for aggregate demand. - Staff policy recommendations: - Continue with accommodative monetary policy to offset market volatility. - Consider providing backstops for systemic non-banks (along with enhanced regulation and supervision) in addition to existing enhanced liquidity facilities for banks. - Protracted period of slower growth (High): - Advanced economies: lower-than-anticipated potential growth and persistently low inflation due to failure to fully address legacies of the financial crisis, leading to secular stagnation. - Emerging economies: maturing of the cycle, misallocation of investment, and incomplete structural reforms leading to prolonged slower growth. - Impact (Medium): reduction in GDP growth; current recovery could stall; widening of the current account deficit. - Staff policy recommendations (Medium): - Continue with accommodative monetary policy for longer to support demand. - Move to neutral fiscal policy stance; allow automatic stabilizers to fully operate. - Implement structural policies to boost investment, productivity and competitiveness. - Growth slowdown in China (Medium): - Scenario: continued buildup and eventual unwinding of excess capacity, eventually resulting in a sharp growth slowdown and large financial and fiscal losses (medium-term). - Impact (Medium): substantial financial linkages through G-SIBs (HSBC and Standard Chartered); limited impact through trade (3 percent of exports are directed to China). ### Macro outlook and staff projections (selected headline figures) - Real Economy (Table 1 — observed and short-term projections): - Real GDP: 2012 = 0.3; 2013 = 1.7; 2014 (Proj.) = 3.2; 2015 (Proj.) = 2.7. - Domestic demand: 2012 = 1.2; 2013 = 1.7; 2014 (Proj.) = 3.0; 2015 (Proj.) = 2.6. - Private final domestic demand: 2012 = 1.3; 2013 = 2.0; 2014 (Proj.) = 3.3; 2015 (Proj.) = 3.5. - CPI, end-period: 2012 = 2.6; 2013 = 2.1; 2014 (Proj.) = 1.9; 2015 (Proj.) = 2.0. - Unemployment rate (in percent) 1/: 2012 = 8.0; 2013 = 7.6; 2014 (Proj.) = 6.5; 2015 (Proj.) = 6.3. - Current account balance (percent of GDP): 2012 = -3.8; 2013 = -4.4; 2014 (Proj.) = -4.0; 2015 (Proj.) = -3.5. - Medium-term projections (Table 2 — selected series): - Real GDP: 2014 (Proj.) = 3.2; 2015 (Proj.) = 2.7; 2016 (Proj.) = 2.5; 2017 (Proj.) = 2.4; 2018 (Proj.) = 2.4; 2019 (Proj.) = 2.4. - CPI Inflation, end period: 2014 (Proj.) = 1.9; 2015 (Proj.) = 2.0; 2016 (Proj.) = 2.0; 2017 (Proj.) = 2.0; 2018 (Proj.) = 2.0; 2019 (Proj.) = 2.0. - Output gap (percent of potential): 2014 (Proj.) = -1.3; 2015 (Proj.) = -0.6; 2016 (Proj.) = -0.3; 2017 (Proj.) = -0.1; 2018 (Proj.) = 0.0; 2019 (Proj.) = 0.0. - Unemployment rate (period average): 2014 (Proj.) = 6.5; 2015 (Proj.) = 6.3; 2016 (Proj.) = 5.9; 2017 (Proj.) = 5.7; 2018 (Proj.) = 5.6; 2019 (Proj.) = 5.5. - Current account (percent of GDP): 2014 (Proj.) = -4.0; 2015 (Proj.) = -3.5; 2016 (Proj.) = -3.1; 2017 (Proj.) = -2.5; 2018 (Proj.) = -1.9; 2019 (Proj.) = -1.2. ### Housing market and financial sector developments (selected observations) - Housing market (Figure 2 observations): - House prices: index normalized to 2008Q1 = 100; UK and London house prices are increasing at a fast pace, particularly in London. - Loan-to-Income Ratio: the loan-to-income ratio is increasing, particularly in London; increases are visible among first-time buyers and movers. - Debt Service Ratio: in an environment of low interest rates the debt service ratio is falling (percent of gross disposable income). - Loan-to-Value Ratio: the loan-to-value ratio has started to increase at the beginning of 2014. - Banking sector comparisons and indicators (Figure 4 observations): - NPA-to-Total Loans 1/: UK declined in 2012 and continued into 2013, albeit from relatively high levels. - Reserves for Loan Loss-to-NPA 1/: NPL coverage ratios are now better than for EU banks. - Efficiency Ratio (non-interest expense/income): has “risen” for UK banks, reflecting drag from conduct/restructuring costs. - Return on Assets: profitability has been weighed down. - Liquid Assets/Total Assets: the share of liquid assets has increased. - Share of Wholesale Funding in Liabilities: post-crisis, EU, UK and US banks have reduced reliance on wholesale funding. ### Fiscal consolidation: progress, composition, and medium-term outlook - Fiscal outcomes and trajectory (Figure 3 and tables): - Public sector overall balance (percent of GDP): 2012 = -6.9; 2013 = -5.8; 2014 (Proj.) = -4.8; 2015 (Proj.) = -3.6. - Public sector cyclically adjusted primary balance (staff estimates): 2012 = -2.6; 2013 = -2.1; 2014 (Proj.) = -1.8; 2015 (Proj.) = -0.7. - General government gross debt: 2012 = 88.5; 2013 = 91.2; 2014 (Proj.) = 92.1; 2015 (Proj.) = 93.0 (percent of GDP). - Public sector net debt: 2012 = 74.2; 2013 = 75.8; 2014 (Proj.) = 77.9; 2015 (Proj.) = 79.1 (percent of GDP). - The deficit has been nearly halved, although the pace of consolidation has been slower than in the original plan. The consolidation thus far has mainly been driven by expenditure measures. - The current government envisages balancing the budget by FY2018. - Public finances (selected fiscal-account figures from staff projections): - Net lending/borrowing (overall balance, percent of GDP): March 2014 Budget actuals and staff proj.: FY2010 = -9.3; FY2011 = -7.6; FY2012 = -6.9; FY2013 = -5.8; FY2014 = -4.9; FY2015 = -3.8; FY2016 = -2.2; FY2017 = -0.9; FY2018 = 0.1 (table context). - Staff projections show gradual improvement in cyclically adjusted balances and primary balances through the medium term. ### Balance of payments and external position (selected figures) - Balance of Payments (Table 6): - Current account (percent of GDP): 2012 = -3.8; 2013 = -4.4; 2014 (Proj.) = -4.0; 2015 (Proj.) = -3.5; 2016 (Proj.) = -3.1; 2017 (Proj.) = -2.5; 2018 (Proj.) = -1.9; 2019 (Proj.) = -1.2. - Trade balance: 2014 (Proj.) = -1.3; 2015 (Proj.) = -1.3; 2016 (Proj.) = -1.2; 2017 (Proj.) = -0.9; 2018 (Proj.) = -0.7; 2019 (Proj.) = -0.6. - Trade in goods: 2014 (Proj.) exports = 17.4; imports = -23.8 (percent of GDP). - Trade in services: 2014 (Proj.) exports = 12.1; imports = -7.1 (percent of GDP). - Income balance: 2014 (Proj.) = -1.0; 2015 (Proj.) = -0.6; 2016 (Proj.) = -0.2; 2017 (Proj.) = 0.0; 2018 (Proj.) = 0.4; 2019 (Proj.) = 1.0 (percent of GDP). *Source: IMF staff report content provided in the source PDF unit.* ### Annex 1. External Sector Report ### Annex 1. External Sector Report ### Overall Assessment - Net international investment position (NIIP) improved from -15 percent of GDP in 2012 to -2 percent in 2013, as a result of valuation effects and changes in the stock of portfolio investment. - Gross positions are about 600 percent of GDP. - Staff projections for the current account and GDP suggest that the NIIP to GDP ratio would decline to about -8 percent by 2019. - Assessment: While the net external position and sustainability issues are not a concern, fluctuations in the underlying gross positions are sources of external vulnerability to the extent that they could lead to large changes in the net position. - Overall Assessment: The external position is moderately weaker than implied by medium-term fundamentals and desirable policy settings. - External deficits reflect insufficient public and private saving rates. - More fundamentally, the external position is influenced by the lack of competitiveness and limited export diversification. Potential policy responses - Sustaining a strong and durable recovery in the UK requires a rebalancing away from public support toward private-sector led demand, along with a greater reliance on external demand. - The current fiscal consolidation plan implemented within a medium-term framework and an accommodative monetary policy stance contribute to the goal of external rebalancing. - Further structural reforms focused on broadening the skill base and investing in public infrastructure will boost productivity, improving the competitiveness of the economy. ### Current account Background - Before the crisis, the UK experienced persistent current account (CA) deficits as a result of an overreliance on public and private consumption. - In the aftermath of the crisis, the CA balance deteriorated primarily as a consequence of a decline in the income balance. This reflects a fall in earnings on UK’s foreign direct investment abroad, notably earnings on investment exposed to the euro area. - The trade balance deficit has remained stable around 2 percent of GDP, despite 16 percent real exchange rate depreciation between 2007 and 2013. - The lack of external adjustment is a result of high trade exposure to the euro area and weak growth of financial service exports. - While investment declined in the aftermath of the crisis, national savings experienced an even larger contraction primarily as a result of lower public savings. - More recently, the household sector savings rate has declined, also contributing to the increase in the CA deficit. Assessment - The EBA CA regression approach estimates a CA gap of around -2.6 percent of GDP. - Based on alternative models and historical CA analysis, staff’s assessment find a cyclically-adjusted CA balance that is 1–2 percent weaker than the current account norm. 1/ ### Real exchange rate Background - In the decade preceding the global crisis (1997–2007), the real effective exchange rate (REER) appreciated 16 percent; since 2007, the REER has depreciated by 16 percent. - The UK experienced an increase in unit labor costs (ULC) of 16 percent since 2007, the largest increase in ULC among G7 economies. - Since July 2013, sterling has appreciated in real effective terms. By May 2014, the REER was 6 percent stronger than its average level in 2013. Assessment - The EBA exchange rate assessment implied by the EBA CA regression model indicates an overvaluation in the range 10–15 percent. - The staff assesses the 2013 REER as 5–10 percent above the level consistent with fundamentals and desirable policy settings; this assessment is consistent with the staff’s CA assessment. 2/ 3/ ### Capital and financial accounts: flows and policy measures Background - Given the UK’s role as an international financial center, portfolio investment and financial derivatives are the key components of the financial account. Assessment - Large fluctuations in capital flows are inherent to financial transactions in countries with a large financial services sector. - This volatility is a potential source of vulnerability. ### FX intervention and reserves level Background - The pound has the status of a global reserve currency. Assessment - Reserves held by the UK are typically low relative to standard metrics (4 percent of GDP at the end of 2013), and the currency is free floating. ### Technical Background Notes - 1/ The difference between the EBA and staff’s CA gap estimate is explained by the treatment of the income balance. Staff has taken the view that recent fluctuations in the income balance are almost entirely cyclical, leading to a smaller estimate of the CA gap. - 2/ The estimate from the EBA REER regression-based approach (which tends to be less reliable than the CA regression-based approach) would suggest an 2013 average REER undervaluation (of 5 percent); this estimate is discarded as implausible, including in light of the assessment that the CA is too weak as well as evidence on competitiveness. - 3/ The difference between the EBA and staff’s exchange rate assessment is accounted by the alternative approaches to estimate the CA balance gap. *Source: Annex 1. External Sector Report, United Kingdom — IMF staff report.* ### 1961. It maintains an exchange system free of restrictions on the making of payments and transfers ### _cr14233 - 1961. It maintains an exchange system free of restrictions on the making of payments and transfers ### Exchange system and targeted sanctions - Exchange regime: maintains an exchange system free of restrictions on the making of payments and transfers for current international transactions, except for exchange restrictions imposed solely for the preservation of national or international security. - Targeted financial sanctions applied under UK legislation in accordance with UN resolutions and EU restrictive measures include persons associated with: - Al-Qaeda and Taliban, and individuals, groups, and organizations associated with terrorism; - the former Government of Iraq; - the former Government of Liberia; - the current Government of Burma (aka Myanmar); - the former Government of the Republic of Yugoslavia and International Criminal Tribunal Indictees; - the current Government of Zimbabwe; - the current government of Belarus; - the current government of North Korea; - the current government of Iran; - persons considered to be a threat to peace and reconciliation in Sudan, Cote d'Ivoire, and Democratic Republic of Congo; - persons considered by the UN to have been involved in the assassination of former Lebanese Prime Minister Rafik Hariri. - These restrictions have been notified to the Fund under Decision 144–(52/51). ### Surveillance, FSAP, and Fund engagement - Article IV Consultation: - Last Article IV consultation concluded on July 15, 2013. - The UK is on the standard 12–month consultation cycle. - FSAP: - FSAP update completed at the time of the 2011 Article IV Consultation. - Next FSAP assessment expected to be conducted in time for 2016 Article IV consultation discussions, in line with the usual five-year cycle for jurisdictions with systemically important financial sectors. - Technical Assistance: None - Resident Representatives: None ### Statistical issues and data practices - Economic and financial data provided to the Fund are considered adequate for surveillance purposes. - The United Kingdom subscribes to the Special Data Dissemination Standard (SDDS) and meets SDDS specifications for coverage, periodicity, and timeliness of data. - SDDS metadata are posted on the Dissemination Standard Bulletin Board (DSBB). - The UK plans to adopt ESA 2010 and BPM6 in September 2014. - Table of Common Indicators Required for Surveillance (As of June 16, 2014) — selected entries with dates/frequencies as reported: - Exchange Rates: Date of latest observation: Same day; Date received: Same day; Frequency of Data: D; Frequency of Reporting: D; Frequency of Publication: D - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation: May 2014; Date received: 06/04/2014; Frequency of Data: M; Frequency of Reporting: M; Frequency of Publication: M - Reserve/Base Money: Date of latest observation: May 2014; Date received: 06/05/2014; Frequency of Data: W; Frequency of Reporting: M; Frequency of Publication: M - Broad Money: Date of latest observation: April 2014; Date received: 06/02/2014; Frequency of Data: M; Frequency of Reporting: M; Frequency of Publication: M - Central Bank Balance Sheet: Date of latest observation: May 2014; Date received: 05/29/2014; Frequency of Data: W; Frequency of Reporting: W; Frequency of Publication: W - Consumer Price Index: Date of latest observation: April 2014; Date received: 05/20/2013; Frequency of Data: M; Frequency of Reporting: M; Frequency of Publication: M - GDP/GNP: Date of latest observation: Q1 2014; Date received: 05/22/2014; Frequency of Data: Q; Frequency of Reporting: Q; Frequency of Publication: Q - External Current Account Balance: Date of latest observation: Q4 2013; Date received: 05/28/2014; Frequency of Data: Q; Frequency of Reporting: Q; Frequency of Publication: Q - Gross External Debt: Date of latest observation: Q4 2013; Date received: 05/28/2014; Frequency of Data: Q; Frequency of Reporting: Q; Frequency of Publication: Q ### Executive Board assessment and policy guidance - Overall assessment: - Executive Directors welcomed the rebound in output and employment amid improved credit conditions and confidence. - The overall policy mix was judged appropriate given remaining slack and a continued weak external environment, with encouragement to adjust policy settings if inflation accelerates. - Fiscal policy: - Directors supported near-term fiscal consolidation efforts while stressing the importance of strengthening public finances without undermining economic growth. - Need to continue medium-term consolidation to put debt on a downward path; encouraged exploring both revenue and expenditure measures with attention to efficiency and equity and maintaining key public services. - Directors welcomed authorities’ efforts to analyze distributional impacts of fiscal consolidation. - Monetary policy and communications: - Maintaining an accommodative monetary policy stance deemed appropriate in the immediate term. - Noted the Bank of England’s intention to raise the policy rate first when normalizing; stressed need for flexibility in sequencing and clear communications from the Monetary and Financial Policy Committees. - Macroprudential and financial stability: - Macroprudential measures should be the first line of defense against housing-market-related financial stability risks; welcomed measures already taken. - Encouraged readiness to adjust limits, modify Help to Buy terms, or undertake new steps if vulnerabilities escalate. - Noted Bank of England may need to raise interest rates if macroprudential measures prove insufficient, with careful consideration of growth and employment implications. - Recommended supply-side measures for house prices including eliminating unnecessary restrictions on development and reforming property taxation. - Urged continued efforts to bolster bank capital, address bank misconduct and the Too-Important-to-Fail problem, monitor shadow banking risks, maintain strong regulatory coordination, ensure international consistency of reforms, broaden stress test scope, and strengthen supervision beyond major banks. - Structural reforms: - Over the medium term, priority areas for structural reforms include infrastructure (transportation and energy), education and training, immigration, and financial intermediation. ### Economic outlook and macro developments (narrative findings) - Growth and demand: - The economy has rebounded strongly; headwinds including adverse credit conditions and diminished confidence have eased. - Signs of demand rebalancing: growth in business investment now ahead of private consumption. - Sustaining strong growth will depend on recovery in productivity growth and real wages. - Net trade has made only a modest contribution to the recovery; the real exchange rate is moderately overvalued. - Monetary stance: - Monetary policy remains highly accommodative; effective monetary conditions have eased compared with last year. - Forward guidance: MPC intention not to raise Bank Rate at least until unemployment fell to 7 per cent (subject to price and financial stability); subsequently clarified in February that rate rises would be gradual and to a level materially below pre-crisis average. - Employment and inflation: - Employment growth remained strong. - Inflation contained and near target. - Current account: - UK’s current account deficit described as large by historical standards: 4.5 per cent of nominal GDP in 2013 (narrative); staff table reports Current account balance: -4.4 (2013). ### Housing market, risks, and macroprudential responses - House price developments: - UK house prices increased by 10.5 per cent in the year to May 2014. - House prices excluding London and the South East increased by 6.4 per cent in the year to May 2014. - House prices in real terms remain around 5 per cent lower than in 2007. - Bank’s central view: annual house price inflation expected to continue at current levels until mid-2015, then slow and grow broadly in line with incomes from 2016. - Household indebtedness and lending standards: - Average gross debt-servicing ratio on new mortgage lending: less than 19 per cent of borrowers’ incomes in recent quarters. - In the four quarters to 2014 Q1, around 10 per cent of lending for house purchase was extended at an LTI at or above four-and-a-half times income; compared to 6.5 per cent in 2005–07. - Mortgage approvals fell for the third consecutive month in April and were 17 per cent below the January 2014 peak. - Policy actions taken and recommended: - Authorities refocused the Funding for Lending Scheme away from mortgages toward small business lending. - More rigorous mortgage standards were introduced earlier in the year. - A UK-tailored stress test (part of EU-wide EBA-coordinated stress test) will assess resilience to a marked fall of 35 per cent in house prices and substantial increase in interest rates. - FPC recommendations after the mission: - Test mortgage affordability against a Bank Rate that is 3 per cent higher than at loan origination. - No more than 15 per cent of a lender’s flow of new mortgages should be at or above four-and-a-half times the borrower’s income. - The LTI limit is intended not to bind now on the market as a whole if the economy evolves in line with the Bank’s central forecasts; measures will bind only if pressures increase above current forecasts. - Fundamental supply-side issue: need to increase housing supply. Government measures at Budget 2014 to support building of over 200,000 new homes, including extension of Help to Buy equity-loan scheme to March (text ends mid-sentence in source). ### Selected economic indicators (2012–15) — reported values - Real Economy (change in percent): - Real GDP: 2012: 0.3; 2013: 1.7; 2014 Proj.: 3.2; 2015 Proj.: 2.7 - Domestic demand: 2012: 1.2; 2013: 1.7; 2014 Proj.: 3.0; 2015 Proj.: 2.6 - Private final domestic demand: 2012: 1.3; 2013: 2.0; 2014 Proj.: 3.3; 2015 Proj.: 3.5 - CPI, end-period: 2012: 2.6; 2013: 2.1; 2014 Proj.: 1.9; 2015 Proj.: 2.0 - Unemployment rate (in percent)1/: 2012: 8.0; 2013: 7.6; 2014 Proj.: 6.9; 2015 Proj.: 6.3 - Gross national saving (percent of GDP): 2012: 10.9; 2013: 10.1; 2014 Proj.: 11.2; 2015 Proj.: 12.1 - Gross domestic investment (percent of GDP): 2012: 14.7; 2013: 14.5; 2014 Proj.: 15.2; 2015 Proj.: 15.6 - Public Finance (fiscal year, percent of GDP)2/: - Public sector overall balance: 2012: -6.9; 2013: -5.8; 2014 Proj.: -4.8; 2015 Proj.: -3.6 - Public sector cyclically adjusted overall balance (staff estimates)3/: 2012: -2.6; 2013: -2.1; 2014 Proj.: -1.8; 2015 Proj.: -0.7 - General government gross debt: 2012: 88.5; 2013: 91.1; 2014 Proj.: 92.0; 2015 Proj.: 92.9 - Public sector net debt: 2012: 74.2; 2013: 75.8; 2014 Proj.: 77.8; 2015 Proj.: 79.0 - Money and Credit (end-period, 12-month percent change): - M4: 2012: -1.0; 2013: 0.2 - Net lending to private sector: 2012: -0.2; 2013: 0.9 - Interest rates (percent; year average): - Three-month interbank rate: 2012: 0.8; 2013: 0.5 - Ten-year government bond yield: 2012: 1.9; 2013: 2.5 - Balance of Payments (percent of GDP): - Current account balance: 2012: -3.8; 2013: -4.4; 2014 Proj.: -4.0; 2015 Proj.: -3.5 - Trade balance: 2012: -2.1; 2013: -1.7; 2014 Proj.: -1.3; 2015 Proj.: -1.3 - Net exports of oil: 2012: -1.0; 2013: -1.1; 2014 Proj.: -0.9; 2015 Proj.: -0.9 - Exports of goods and services (volume change in percent): 2012: 1.7; 2013: 1.0; 2014 Proj.: 1.9; 2015 Proj.: 3.3 - Imports of goods and services (volume change in percent): 2012: 3.4; 2013: 0.5; 2014 Proj.: 1.4; 2015 Proj.: 3.0 - Terms of trade (percent change): 2012: -0.3; 2013: 0.9; 2014 Proj.: 0.3; 2015 Proj.: -0.1 - FDI net: 2012: -0.4; 2013: -0.7; 2014 Proj.: -0.5; 2015 Proj.: -0.6 - Reserves (end of period, billions of US dollars): 2012: 99.9; 2013: 101.5 - Fund Position (as of May 31st, 2014): - Holdings of currency (in percent of quota): 75.8 - Holdings of SDRs (in percent of allocation): 95.2 - Quota (in millions of SDRs): 10,738.5 - Exchange rates: - Exchange rate regime: Floating - Bilateral rate (June 17th, 2014): US$1 = £0.5896 - Nominal effective rate (2005=100)4/: 2012: 82.1; 2013: 80.1 - Real effective rate (2005=100)4/5/: 2012: 89.3; 2013: 88.5 *IMF Executive Board Concludes 2014 Article IV Consultation with the United Kingdom; Press Release No.14/365; July 28, 2014* ### 2020. The Government has also introduced the National Planning Policy Framework (NPPF) ### _cr14233 - 2020. The Government has also introduced the National Planning Policy Framework (NPPF) ### Planning and construction approvals - The National Planning Policy Framework (NPPF) replaces the previous fragmented system with a unified framework. - Planning approvals are at their highest level since 2008 with 88 per cent of applications approved in Q4 2013. - 174,000 planning permissions granted in England in 2013, the highest annual figure since 2007. ### Deficit reduction and public debt - The deficit is forecast to have fallen by a half as a percentage of GDP by 2014-15, but it will still be too high at 5.5 per cent. - The OBR expects public sector net debt to be 74.5% of GDP this year and expects it to peak at 78.7% in 2015-16 – lower than the 80% previously forecast - before falling. - General government gross debt is expected to peak at 93.1 per cent in 2015-16. - The government welcomes the IMF’s judgment that the pace and composition of the deficit reduction in the near-term and the goal to eliminate the overall deficit by 2018-19 is appropriate. - The UK general election is scheduled for 7 May 2015; detailed fiscal consolidation plans are only specified through 2015/16. - The Chief Secretary to the Treasury has asked the Minster for the Cabinet Office to set out an ambitious new efficiency programme to deliver savings from 2016-17 and across the next Parliament. - The government’s fiscal consolidation plan envisaged a split of 80 - 20 between spending and tax; all the tax measures have been delivered. - Efficiencies and waste reduction have already yielded savings of £20 billion a year compared to 2009-10. - Spending Round 2013 identified a further £5 billion additional efficiency savings in 2015-16. - The government has brought a material amount of spending under new controls through the introduction of the welfare cap: a nominal spending limit for “welfare in scope” (state pension and counter-cyclical spending excluded) starting from 2015-16. - The OBR will report annually on the government’s performance against the cap, starting in Autumn 2014. - Government fiscal-event analysis shows the top income quintile households make the greatest contribution to reducing the deficit, both in cash terms and as a percentage of their income and benefits in kind from public services. - In December 2013 the government announced a review of the current fiscal framework; the outcome will inform an updated Charter for Budget Responsibility, to be presented to Parliament alongside Autumn Statement 2014. ### Structural reform and infrastructure investment - Structural reforms remain very high on the government’s agenda to rebalance and strengthen the economy, with particular focus on prioritising infrastructure investment. - The government has switched current spending to capital spending to support the quality of fiscal consolidation and long-term productivity growth. - In June 2013, the government set out commitments for over £100bn of capital spending out to 2020-21. - The National Infrastructure Plan 2013 sets out a refreshed infrastructure pipeline of investment worth over £375 billion. - The NIP includes a provision of up to £40 billion of support for critical infrastructure projects through the UK Guarantees Scheme. - At Budget 2014 the government expanded the Apprenticeship Grants for Employers scheme, providing an extra £85 million in both 2014-15 and 2015-16 for over 100,000 grants to employers. ### Reform of the financial system - Delivering and completing necessary financial regulatory reforms and repair continues to be a priority. - A new more focused architecture for judgment-led financial regulation and supervision has been up and running since April 2013. - The FPC decided in June to close its recommendation of March last year that the largest UK banks and building societies should meet a minimum 7 per cent Common Equity Tier One ratio (set out in the EU rules to implement Basel III) after adjustments for expected future losses, future conduct costs, and a more prudent calculation of risk weights. - The Prudential Regulation Authority has moved to using a baseline leverage ratio more rapidly than the international standard requires; the FPC is consulting on the scope and form of its application. - The EBA announced details of its 2014 stress-testing exercise; several UK banks and building societies will participate in a UK variant focusing on a housing shock. - The Banking Reform Act, which received Royal Assent in December 2013, introduces significant structural and cultural changes including power to require the ‘ring-fencing’ of the deposits of individuals and small businesses and powers to ensure banks are more able to absorb losses. - In June, the Bank announced it would extend the scope of its liquidity facilities to the UK’s biggest broker dealers and to central counterparties. - Progress continues on the global financial reform agenda, including work on shadow banking, cross-border resolution, and enhancing competition in the financial sector. - The government announced a joint review by the Treasury, the Bank and the Financial Conduct Authority (FCA) into the way wholesale financial markets operate, building on FCA reforms of LIBOR and the Parliamentary Commission on Banking Standards which led to a new legal regime for senior managers. *IMF staff report content from the provided PDF chapter/section.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14233.pdf_