United Kingdom — 2016 Article IV Consultation Concluding Statement of the Mission
IMF News, May 13, 2016
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- Published: May 13, 2016
Outlook and risks
- The Article IV mission took place as the British people prepared for a referendum on EU membership; uncertainty over the referendum outcome is already affecting investment and hiring, with recent surveys of economic activity falling to their weakest levels in three years.
- Baseline (Remain) forecast:
- Growth likely to fall below 2 percent for the full-year 2016.
- Growth expected to rebound in the second half of 2016 and return to an average of around 2¼ percent over the medium term, roughly in line with potential.
- Inflation currently only ½ percent and expected to revert to target gradually as commodity price effects dissipate and low unemployment pushes up wages.
- Key ongoing vulnerabilities:
- Low household saving rate.
- Still-high levels of household debt.
- Fiscal deficits, despite substantial reductions since the crisis.
- Wide current account deficit (widened further in late 2015).
- Risk that productivity growth may remain low for an extended period (productivity growth slowing).
- The largest risks relate to the upcoming EU referendum; a Leave vote could crystallize baseline vulnerabilities and create heightened uncertainty.
Possible economic effects of an exit from the EU
- Short- to medium-run effects:
- A vote for exit would precipitate a protracted period of heightened uncertainty, financial market volatility, and a hit to output.
- Post-decision the UK would need to negotiate withdrawal terms and a new relationship with the EU (unless abandoning single market access and relying on WTO rules, which would significantly raise trade barriers).
- Ratification of a new deal likely to require unanimous consent of all EU member governments, adding political risk.
- Existing EU-level agreements cover the UK’s trading relationship with 60 non-EU economies (and prospective arrangements with another 67 countries are in the works); the UK would need to renegotiate these or see them revert to WTO rules.
- These processes could remain unresolved for years, weighing on investment and economic sentiment and depressing output.
- Volatility in key financial markets would likely rise.
- Long-run effects:
- Most assessments point to sizable long-run losses in incomes from increased barriers that reduce trade, investment, and productivity.
- Range of estimated long-run losses: from 1½ to as much as 9½ percent of GDP.
- Any output losses in excess of 1 percent of GDP would result in net fiscal losses, since reduced revenue would more than offset eliminating the UK’s net EU budget contribution of 1/3 percent of GDP.
- London’s status as a global financial center could be eroded (loss of passporting rights; euro-denominated business may move to the continent).
- Risk of market anticipation and abrupt reactions:
- Potential sharp drops in equity and house prices, increased borrowing costs, and sudden stop of investment inflows (e.g., commercial real estate and finance).
- Current account deficit and reliance on external financing exacerbate these risks.
- Limited support for net exports from abrupt sterling depreciation would only partly offset GDP losses; inflation could rise well above target for some time.
- Contagion effects possible, with primary impact domestic.
- Recent market developments indicative of increased uncertainty:
- Commercial real estate transactions plunged about 40 percent in Q1 2016.
- Sterling depreciated by 9 percent in trade-weighted terms since November.
- Cost of insuring against a UK sovereign default has doubled (albeit from a low level).
- Cost of insuring against exchange rate volatility around the referendum has spiked.
- Recommended crisis responses in the event of a Leave vote:
- Policies should be geared to support stability and reduce uncertainty.
- Ensure the financial system has adequate liquidity; Bank of England has announced plans to hold additional liquidity auctions in the weeks around the referendum.
- Consider activating swap facilities with other major central banks if foreign exchange liquidity is short.
- Macroeconomic policy trade-offs: between stabilizing inflation and stabilizing output and employment; scope to cushion a sharp fall in activity depends on supply/demand assessment and inflation expectations.
- Develop plans for additional medium-term budget consolidation to offset longer-run adverse fiscal effects.
Macroeconomic policies
- Under a Remain baseline, focus should be on promoting steady growth while reducing vulnerabilities via:
- Fiscal consolidation over the medium term to rebuild buffers—gradual and flexible enough to avoid overburdening monetary policy and to adjust to shocks.
- Continued accommodative monetary policy to offset fiscal headwinds and support growth.
- Sufficiently tight macroprudential policies to mitigate financial stability risks associated with high household debt.
- Structural reforms to boost productivity and incomes.
- Fiscal policy specifics:
- The March budget avoided additional near-term tightening to offset lower revenue projections after the Office for Budget Responsibility’s growth downgrade.
- The budget targeted additional adjustment in the outer years to maintain the government’s target of fiscal balance by FY19/20.
- Backloading was appropriate given near-term growth weakness and heightened uncertainty.
- Fiscal policy should remain flexible; in an extended period of sluggish demand and inflation undershooting, authorities should ease the pace of structural adjustment allowed under the fiscal framework.
- Strengthen pro-growth and pro-stability aspects of consolidation—top priority: further boost infrastructure spending.
- Funding options for increased infrastructure: scale back distortionary tax expenditures (e.g., nonstandard VAT rates) to increase efficiency and tax neutrality.
- Enhance financial stability by reducing tax code bias toward debt—e.g., adopt an Allowance for Corporate Equity with offsetting changes in other corporate tax parameters.
- Monetary policy specifics:
- Remain accommodative to support growth and ensure inflation returns to target.
- Core inflation below target and wage growth muted; clearer signs of inflationary pressure should precede any tightening.
- If risks of prolonged low demand and inflation undershooting rise, monetary policy may need to be eased via policy rate cuts and quantitative easing.
Financial sector policies
- FSAP findings and recommendations:
- Main parts of the UK financial system appear resilient due to post-crisis regulatory reforms: banks have more than doubled their risk-weighted capital ratios from pre-crisis levels, strengthened liquidity, and reduced leverage.
- Stress tests indicate large banks, insurers, asset managers, and central counterparties appear resilient to shocks.
- Interconnectedness across sectors could amplify shocks and turn sector-specific distress systemic—priority to strengthen analysis and data on interconnectedness and related risks.
- Progress toward resolvability of financial firms achieved, but further efforts needed to complete reform agenda and ensure resolvability, especially for systemically important firms.
- Authorities should develop operational principles for funding firms in resolution and work with international partners on effective resolution regime for systemically significant insurance firms.
- Supervisory stance:
- Maintain a robust and intrusive approach to prudential supervision and regulation as the financial cycle matures.
- Continue prudent review of dividend payouts.
- Proactively challenge banks’ internal risk-weight models, including through stress testing.
- Seek international agreement on maintaining effective standards for risk-weights.
- De-risking and correspondent banking:
- UK global banks have been reviewing account relationships in response to post-crisis deleveraging, conduct and governance reforms, and reduced risk appetite.
- Decline in correspondent banking relationships has led to account terminations for categories such as money transmitters and non-profit organizations.
- Authorities should tailor responses: promote stakeholder dialogue, clarify regulatory expectations, and enhance AML/CFT supervision of money transmitters.
Macroprudential policy
- Housing and mortgage markets:
- Macroprudential tightening between mid-2014 and mid-2015 decelerated markets, but activity has recently increased.
- House price growth rose to more than three times income growth.
- Share of new mortgages at high loan-to-income (LTI) ratios is again rising.
- Recent increased activity may partly reflect a temporary rush before higher transaction taxes on some home purchases effective in April.
- If trends persist, further macroprudential tightening (e.g., tighter LTI or loan-to-value limits) will be needed later in 2016 to avoid financial stability risks from excessive household indebtedness.
- The buy-to-let market has grown rapidly and should be subject to macroprudential measures similar to the owner-occupied market following the now-concluded Treasury consultation.
- Commercial real estate:
- Monitor risks closely; rapid price growth during 2014-15 has recently paused.
- Broader macroprudential stance:
- Remain focused on financial stability and stand ready to act.
- Communicate objectives and tools of the Financial Policy Committee to a broader audience.
- Raise the countercyclical capital buffer (CCB) as warranted by credit and asset price conditions; the CCB may well need to be increased later in 2016.
Structural reforms
- Housing supply:
- Top priority: boost housing supply to support growth (construction) and bolster financial stability by increasing affordability and reducing need for high household debt.
- Recommended measures: ease planning restrictions, mobilize unused publicly-owned land for construction, and reform property taxes to encourage efficient use of housing stock (as recommended in the Mirrlees Review and recent IMF reports).
- Labor market and inclusion:
- Expand vocational training, including more high-quality apprenticeships, to reduce double-digit youth unemployment and make growth more inclusive.
- Increase childcare support to boost labor force participation by single women with children (participation remains below the OECD average despite recent rapid improvement).
- Corporate transparency and AML/CFT:
- Government adopted comprehensive reforms: establishment of a register of people with significant control (beneficial ownership) of UK companies and limited liability partnerships; new initiative for automatic sharing of beneficial ownership information between countries.
- Complementary measures needed: enhance AML/CFT regulatory compliance among trust and company service providers, lawyers, and accountants; strengthen effectiveness of their AML/CFT supervision.
- Crown Dependencies (CDs) and British Overseas Territories (BOTs) with financial centers committed to establishing central beneficial ownership registries or equivalent systems; government concluded arrangements on effective and unrestricted access to this information by law enforcement and tax authorities.
- Success depends on ensuring quality of beneficial ownership information (including public accessibility), adequate enforcement, and pursuing similar initiatives for trusts.
United Kingdom — 2016 Article IV Consultation Concluding Statement of the Mission (May 13, 2016).