United Kingdom: Staff Concluding Statement of the 2017 Article IV Mission

IMF News, December 20, 2017

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• Published: December 20, 2017

Macroeconomic outlook and risks

• Recent performance and drivers
  • Output is expected to grow by 1.6 percent this year, broadly in line with the IMF staff estimate of the economy’s potential.
  • Growth in the first three quarters of 2017 was slower than a year ago.
  • Employment rate has remained around record highs.
  • Sharp depreciation of sterling following the referendum pushed up consumer price inflation, squeezing household real income and consumption.
  • Business investment growth has been lower than would be expected given strong global growth and high capacity utilization.
  • Softening domestic demand was partially offset by a rise in goods exports, supported by strong growth in trading partners and weaker sterling.
• Near-term projection
  • Growth is projected to remain around 1½ percent next year.
  • Inflation is expected to fall gradually but stay above target, implying further pressure on real wages and private consumption.
  • Projections assume continued progress in Brexit negotiations, culminating in understandings on a broad free trade agreement and on the transition process.
• Key risks to the baseline
  • Brexit negotiation outcomes: faster-than-expected progress could buoy confidence; a breakdown could lead to a disorderly exit and sharp falls in asset prices.
  • Compressed risk premia and a decline in liquidity in the UK corporate bond market.
  • Still-high valuations of commercial real estate and, to a lesser extent, housing.
  • Low household saving rate.
  • Large current account deficit magnifies vulnerability to shifts in investor expectations.
• Structural and long-term considerations
  • Brexit could reshape the structure of the UK economy; impact depends on the nature of the final agreement and may take many years to materialize.
  • The financial sector represents about 7 percent of GDP, accounts for around 10 percent of tax revenues and 14 percent of exports; it may be particularly affected absent an agreement preserving EU-facing financial services provision from the UK.
  • Manufacturing firms with complex international supply chains, such as in the automobile industry, could face significant challenges.
  • Productivity growth is the primary determinant of long-run living standards:
  • Since the financial crisis, output growth has been underpinned by strong employment increases, while productivity growth has been extremely weak.
  • Under the baseline assumption that labor productivity growth doubles to 1 percent from the ½ percent annual average since the financial crisis, potential growth will be only about 1½ percent per year in the medium run.
  • Higher barriers to cross-border flows of services, goods and workers would have more negative impacts on productivity.

Monetary and fiscal policies

• Monetary policy actions and guidance
  • The Bank of England eased policy following the Brexit Referendum: Bank Rate was cut by 25 basis points, another round of quantitative easing was initiated, and the Term Funding Scheme (TFS) was introduced.
  • TFS has supported lending to the private sector according to banks.
  • Since then, inflation has risen above 3 percent, mostly reflecting exchange rate pass-through.
  • The Monetary Policy Committee (MPC) voted at its November meeting to raise Bank Rate by 25 basis points, reversing the earlier cut.
  • Withdrawal of monetary stimulus should continue at a gradual pace, in line with the MPC’s policy guidance.
  • Scaling down of the Bank of England’s balance sheet should await the return of Bank Rate to a level from which it could be cut materially in the event of a demand slowdown.
  • Transparent and timely communication remains critical to guide market expectations.
• Fiscal policy stance and recommendations
  • Continued deficit reduction is critical to rebuild fiscal buffers.
  • Public debt ratio stands at 87 percent of GDP.
  • All three main credit rating agencies downgraded the UK’s sovereign debt rating since the referendum.
  • The fiscal framework aims to reduce the deficit (after accounting for the impact of the economic cycle) to below 2 percent of GDP by 2020/21, and to balance the budget by the middle of the next decade.
  • Recent smoothing of the annual profile of deficit reduction accommodates higher public investment while continuing progress toward framework objectives.
  • Automatic stabilizers should be allowed to operate freely in response to demand shocks.
• Long-term fiscal pressures
  • Population aging will put pressure on public finances; OBR projects annual spending on healthcare, long-term care and pensions is projected to increase by 1 percent of GDP between 2020 and 2025, and by much more thereafter.
  • Each 1 percentage point decline in GDP is estimated to decrease net revenues by about 0.4 percent of GDP.
  • Movement of a meaningful share of the financial sector outside the UK could reduce available revenues faster.
  • Losses associated with a 1 percentage point decline in long-run output would more than offset gains from any net savings from lower contributions to the EU budget post-Brexit.
• Tax and spending policy recommendations
  • Greater reliance on revenue measures for consolidation may be warranted; deficit reduction since the financial crisis has relied mostly on spending measures.
  • Tax reforms suggested:
  • Scale back preferential VAT rates for certain goods to increase tax neutrality.
  • Better align the tax treatment of employees and the self-employed to improve fairness.
  • Adopt a tax allowance for corporate equity to reduce the tax code’s bias toward debt.
  • Rebalance property taxation away from transactions and toward values to boost mobility and efficient use of housing stock.
  • Spending-side recommendation: remove the triple lock on pensions to help contain rising demographic spending over the long term.
• Fiscal transparency
  • OBR released its first Fiscal Risk Report assessing vulnerabilities of public finances.
  • Authorities have improved oversight for contingent liabilities and will respond more fully by next summer.
  • First-of-its-kind fiscal stress test shows public finances can deteriorate quickly under confluence of negative shocks.
  • From Autumn 2017 budget, major tax and spending decisions unified into a single fiscal event earlier in the financial year to allow more scrutiny and certainty.

Financial sector policies

• Banking system resilience
  • UK banks’ capital, leverage, and liquidity positions are well above international regulatory minima.
  • Bank of England stress tests indicate major UK banks are sufficiently well-capitalized to withstand simultaneous UK and global recessions, large falls in asset prices, and stressed misconduct costs.
  • Major bank resolution reforms are being implemented, including ring-fencing, total loss-absorbing capacity and resolution planning requirements.
• Emerging risks and supervisory actions
  • Consumer credit has grown rapidly over the last two years; increasing competition has compressed spreads on mortgage and consumer loans.
  • Consumer credit developments need close monitoring; further action may be necessary if high growth persists, including enhanced oversight of nonbank financial institutions.
  • Recent increase in the countercyclical capital buffer was appropriate; its level should be kept under review.
  • Adopting the Basel III finalization agreement would help reduce excess variability in risk weights across banks using internal models.
  • Supervisors should continue scrutinizing banks’ risk weights and adjust PRA capital buffers where necessary.
  • Consider conducting a system-wide liquidity stress test of the major UK banks in a future biennial exploratory scenario.
• Brexit-related financial sector challenges
  • Stress tests suggest major UK banks are sufficiently well-capitalized to withstand a disorderly Brexit, but even an orderly Brexit could imply significant sectoral changes.
  • Prudential regulators and supervisors have taken a proactive approach to help firms prepare for exit from the EU.
  • Authorities are translating EU financial regulations into UK law and replicating EU institutional capacity where necessary.
  • Some areas (continuity of long-dated cross-border insurance and derivatives contracts, transfer of personal information across borders) are best achieved through coordinated EU and UK legislation; early agreement and a sufficiently long transition period would reduce uncertainty.
  • Close cross-border regulatory and supervisory cooperation remains essential, especially regarding euro-denominated derivatives clearing on UK-based central counterparties and permissions for EU banks.

Contingency planning (tail risk scenario)

• Policy stance under a disorderly Brexit
  • Policies should be geared toward supporting macroeconomic and financial stability.
  • Bank of England should ensure adequate financial system liquidity and maintain swap lines with other major central banks if adverse market reactions occur.
  • Monetary policy implications depend on relative shifts of supply, demand and the exchange rate.
  • Fiscal framework flexibility could be used to provide support, but easing should be temporary, limited and anchored by credible medium-term fiscal consolidation plans.
  • A permanent shock to output would require an eventual adjustment of revenues or spending.

Structural reforms

• Productivity-enhancing measures
  • Public infrastructure investment has increased; budget envisages further capital spending increases over the medium term, including through the National Productivity Investment Fund.
  • National Infrastructure Commission will release its first National Infrastructure Assessment next year.
  • Human capital measures: T-level qualifications and the apprenticeship levy aim to raise job-specific skills, promote higher level technical skills and reduce regional disparities.
  • Monitor and evaluate effectiveness of these programs once established.
  • Housing supply measures announced, but continued efforts needed: ease planning restrictions and reform property taxes to address chronic shortages preventing worker relocation.
• Regional productivity differences
  • UK has some of the highest and some of the lowest productivity regions among advanced economies.
  • No single solution: successful regions need to address congestion and housing restrictions; other regions should increase human capital and improve transport connectivity.
  • Greater local decision-making could better tailor policies to local conditions, including technical training eligibility and curricula.
• Transparency and anti-money laundering
  • 2017 Money Laundering Regulations and the Criminal Finances Act adopted; second National Risk Assessment of money laundering and terrorist financing completed.
  • Establishment of central registers for companies and trusts is positive; mechanisms to verify ownership information should be strengthened.
  • Improve AML/CFT supervision of trust and company service providers (including lawyers and accountants) to ensure accurate ownership information accessible by tax and law enforcement authorities.
  • Continued engagement with Crown Dependencies and Overseas Territories on exchange of information on companies and trusts is critical.

International Monetary Fund, Staff Concluding Statement of the 2017 Article IV Mission for the United Kingdom

References

• 2017 UK Article IV Press Conference: Opening Remarks by IMF Managing Director Christine Lagarde
• United Kingdom and the IMF
• IMF Policy Advice -- A Factsheet
• The IMF and the Fight Against Money Laundering and the Financing of Terrorism
• Mission Concluding Statements
• PRESS CENTER
• https://www.imf.org/en/home