Concluding Remarks of 1998 Article IV Consultation--United Kingdom

December 21, 1998

At the conclusion of annual Article IV bilateral discussions with the authorities, and prior to the preparation of the staff's report to the Executive Board, the IMF mission often provides the authorities with a statement of its preliminary findings.
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United Kingdom -- 1998 Article IV Consultation
Concluding Statement of the Mission
December 21, 1998

The United Kingdom has enjoyed strong economic performance in recent years. Real growth has been high, unemployment rates have fallen to historically low levels, and inflation has remained low and close to the Government’s target. Indeed, by early 1998 performance became in some respects too strong, and a threat of overheating emerged. The economy is now weakening, possibly more than needed for sustainability because of adverse external developments. But private sector fundamentals are strong; and past policies have ensured that monetary policy is well placed to respond appropriately, and fiscal policy to utilize fully the automatic stabilizers. It is likely, therefore, that the slowdown will be short-lived, although there are downside risks stemming from the still high value of sterling, an inventory overhang, and continuing uncertainty regarding the world economy.

The strong economic performance of the past few years and the increased credibility evident in market data owe much to the record of good policies, underpinned as they are by the shift in the focus of policy making towards setting and achieving clear medium-term goals. The current Government, building on past reforms, is putting in place an architecture that emphasizes division of responsibilities, clear lines of accountability, and explicit targets against which performance can be transparently judged. We look forward to the full implementation of these initiatives, which are in line with evolving best practices internationally (where the United Kingdom is in the vanguard).

The best example of this strategy remains the Government’s decisions with respect to the Bank of England. These focused the activities of the Bank (and the Treasury) by making it independent and accountable for controlling inflation, and by shifting potentially conflicting and not intrinsically related responsibilities (banking supervision and debt management) to others. Equally central have been the clear mechanisms of accountability of the Bank, reinforced by the clarity and symmetry of its remit (to keep inflation as close as possible to 2 ½ percent without incurring unnecessary output costs).

The way the Bank and the MPC have responded to this charge is impressive. The process leading up to policy decisions is professional and focused on bringing together in a systematic and comprehensive way the elements that might foreseeably affect inflation over the next several years. We are particularly impressed by the way the members of the MPC have, collectively and individually, taken up and made their own this task of looking forward--an essential one for lastingly good outcomes. For this to be sustained, the MPC needs to continue to be comprised of individuals with the training, judgement, and breadth of viewpoint and experience needed to carry out this task.

As regards accountability, we welcome the steps taken by the MPC to enhance further the transparency of the process. We particularly welcome the decision to shorten the publication lag of the minutes of MPC meetings to only two weeks, thus allowing the public to assess the reasoning of the Committee before the subsequent meeting. The current style of the minutes, which gives a flavor of the policy debate and of the differing opinions within the Committee, provides significant and useful information, and it should be retained. The Inflation Report, which has become the flagship publication of the Committee, provides a comprehensive overview of recent developments. However, the forward-looking aspects of the analysis would benefit from a more complete and accessible discussion, as in the minutes, of the range of considerations and views that inform policy decisions.

Overall, this framework has resulted in decisions well tuned to the ebb and flow of the inflationary (or deflationary) outlook. We particularly welcome the prompt response in recent months to weakening prospects, a responsiveness which we and the markets fully expect to see continue.

Looking further ahead, the Government should consider shifting to an inflation target cast in terms of the Harmonized Index of Consumer Prices (HICP). Clearly, such a decision should not be taken lightly since a foremost consideration should be preserving the credibility of monetary policy. Nonetheless, the reasons for shifting at some point seem compelling. Though the HICP is still under development, it is generally considered the technically superior index. Moreover, it is the index most comparable to that used elsewhere in Europe, an important consideration in the context of achieving convergence. Finally, a target cast in terms of the RPIX appears to needlessly sell short the extent of the U.K.’s inflation convergence: the U.K. inflation rate, when measured by the HICP, is near the European average.

Turning to fiscal policy, the degree of fiscal consolidation achieved by the Government since coming to office can only be viewed as highly commendable. As a result of these efforts, the budget is now essentially in balance in cyclically adjusted (or structural) terms and the ratio of debt to GDP is on a downward course. These actions have laid the foundation for fiscal sustainability over the medium term within a structure that can allow full play to the automatic stabilizers in the event of a downturn. The challenge looking forward is to preserve and solidify this foundation.

The Government has responded to this challenge with a fiscal framework that broadly meets the requirements of the Fund’s Code of Fiscal Conduct and consists of three main strands. First, two aggregate fiscal rules that apply over the business cycle--the golden rule, which precludes debt financing of current spending, and the debt rule, specifying a stable and prudent public debt to GDP ratio--place limits on the scope for future policy action. Second, budgetary plans and expenditure limits are designed to keep budget outturns prudently within these limits over the next three years. And, third, new procedures--notably Public Service Agreements and associated performance commitments, and the process for evaluating departmental investment plans--provide incentives to help ensure that spending plans will be respected and money will be well spent.

If implemented, this framework and the parallel commitment to transparency should help to ensure the stability of the public finances. In this respect, we would emphasize the need for the Government to stick to its plans and maintain a prudent margin relative to the medium-term limits specified by the aggregate rules. The Government’s credibility in this area is of recent vintage, and needs to be reinforced by continuing fiscal prudence. In addition, the plans already imply a moderately expansionary thrust. While this is welcome in view of the immediate risks to growth and to make room for increased public investment, if current spending were to rise faster than GDP over the medium term the scope for tax cuts of various kinds would be unduly limited.

In adhering to present plans, particularly careful watch will be needed in three areas:

--The three-year Departmental Expenditure Limits. These will be tested, but need to be respected. These limits usefully allow some flexibility, in that resources can be shifted within each department and shifted forward should an annual budget be undershot. More generally, substantially more detailed information in the core budget documents on past and planned spending by major functions and program areas would significantly increase transparency and accountability.

--Tax expenditures. These tend to be forgotten, even though they cumulate over time, cause unwanted distortions, and impart a negative drift to the public finances. Strict enforcement of Departmental Expenditure Limits could result in pressures to introduce or expand tax expenditures. As a first step, it would be desirable to have a more transparent account of all existing as well as proposed tax expenditures in the core budget documents.

--The efficiency of public spending. The Government should continue to build on the progress already made in ensuring that public money is well spent. The decision to increase public sector investment, while overdue, carries with it the risk of waste. To prevent this, the mechanisms for evaluating investment projects, as reflected in the Departmental Investment strategies, need to be rigorous and transparent. With regard to spending more generally, we welcome the recently published Public Service Agreements, and the associated commitments of each department to achieve specific, often ascertainable goals. This should help instill an output-oriented culture, but only if shortcomings in performance are duly evaluated and the proper implications drawn.

As regards other policies, the Government has reformed financial sector regulation by establishing the Financial Services Authority (FSA), an initiative that should prompt improvements. In the United Kingdom, where financial regulation has been spread thus far among nine separate bodies, the shift to a single regulator will clarify regulation and improve supervision of increasingly integrated multi-sector financial institutions. Unified supervision of complex financial groups will also strengthen the FSA’s ability to regulate the City’s large, internationally integrated financial market. Consumer protection, a major mandate of the FSA, should also be strengthened and become more uniform. As regards risks, the separation of banking supervision and lender-of-last-resort responsibilities will require the FSA and the Bank of England to act in close coordination. The combination of formal structures and working-level relationships that link the two institutions seems appropriate, and should provide the Bank with the supervisory information it needs to fulfill its lender-of-last-resort mandate.

Turning to other structural reforms, we welcome the emphasis on policies to help vulnerable groups while encouraging greater individual responsibility, efficiency, and flexibility. The New Deal emphasizes active policies to promote greater participation in the labor force, thereby reducing exclusion. These policies are reinforced by the proposed Working Families Tax Credit and changes to National Insurance Contributions, which encourage work by reducing marginal effective tax rates at the low end. Finally, the recently proposed pension reform would also help low income groups, although its economic effects and costs need to be analyzed further, especially as regards the implications for the rather low level of national saving.

Over the medium term, a key decision confronting the United Kingdom is whether and when to join EMU. We welcome the preliminary contingency plans the Government is making regarding the procedural aspects. As regards the economic aspects, the Government’s five tests identify the issues. Moreover, its stability-oriented policies offer a realistic prospect of increasing convergence over the next few years. Adoption of the euro would nevertheless involve a considerable regime change for the U.K. economy, and it is essential that all aspects of such a change, including the structural ones, be reviewed and addressed on an ongoing basis.

We commend the authorities for their initiatives to relieve the poorest countries’ debt problem and for their commitment to reverse the downward trend in U.K. overseas aid spending. We encourage the authorities to accelerate progress toward the U.N. target of 0.7 percent of GDP.