United Kingdom: Staff Concluding Statement of the 2018 Article IV Mission
IMF News, September 17, 2018
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- Published: September 17, 2018
Outlook and Risks
- Growth moderated since the European Union referendum in June 2016; uncertainty over the terms of the EU withdrawal has weighed on private sector activity.
- Above-target inflation following the sharp post-referendum sterling depreciation has slowed real income and consumption growth.
- Business investment has been lower than would be expected in the context of robust global growth and favorable financing conditions.
- Softening domestic demand was partially offset by a higher contribution from net exports, supported by weaker sterling and strong external demand.
- Overall growth fell to about 1¾ percent in 2016-17, moving the United Kingdom from the top to near the bottom of the G7 growth tables.
- Employment rate continues to reach record highs.
- Baseline projection assumes timely agreement on a broad trade pact covering goods and some services and a relatively smooth Brexit process thereafter.
- Growth is expected to average about 1½ percent this year and next under the baseline.
- Risks to the baseline:
- A more disruptive departure from the EU could lead to a significantly worse outcome, especially if it were to occur without an implementation period.
- An agreement featuring fewer impediments to trade than currently expected could lead to faster growth.
- Brexit negotiations yielded agreement in principle on a 21-month implementation period; fundamental questions (future economic relationship with the EU and status of the land border with Ireland) remain unanswered.
- An agreement that minimizes new tariff and nontariff barriers would best protect growth and incomes in the UK and EU; new trade agreements with countries outside the EU are unlikely to fully offset costs of leaving the EU.
- Government Brexit preparations include transposing EU laws into UK law, guaranteeing EU program funding committed to projects in the UK before the end of 2020, ensuring access to critical items like medicines, a budgetary allocation of £3 billion for Brexit preparation, and hiring thousands of civil servants.
- Government has begun publishing technical notices for private stakeholders to prepare for a “no deal” scenario.
- Remaining preparation tasks are large: bolster customs resources, establish domestic agencies to replace EU ones, renegotiate hundreds of bilateral and multilateral agreements; many tasks cannot begin until greater clarity on the future trade relationship.
- Coordination and cooperation between EU and UK on priority issues (e.g., air traffic continuity) and joint technical discussions between UK and EU experts are recommended.
Monetary and Fiscal Policies
- After a cumulative 50 basis point increase in Bank Rate over the last 12 months, further withdrawal of monetary stimulus should await clear confirmation of a durable rise in domestic cost pressures.
- The inflationary impact of the post-referendum depreciation of sterling should continue to fade.
- Domestic inflation likely to firm as the tight labor market pushes real wage growth above productivity growth.
- If excess demand pressures persist after domestic inflation approaches 2-percent target, further gradual tightening of monetary policy would be warranted.
- Policymakers should respond flexibly to data in an environment of greater-than-usual uncertainty; if negative surprises depress domestic demand, accommodative conditions should be maintained for longer.
- Scaling down of the Bank of England’s balance sheet should await return of Bank Rate to a level from which it could be cut materially in the event of a demand slowdown, consistent with the Monetary Policy Committee’s current plans.
- Transparent and timely communication to guide market expectations is essential.
- Steady fiscal consolidation remains critical to comply with the government’s fiscal framework and to put debt firmly on a downward path.
- Recently-announced increase in public health spending should be financed from new revenue sources and/or offsetting spending cuts elsewhere in the budget.
- In the absence of offsetting measures, the margin against the cyclically adjusted deficit ceiling of 2 percent in 2020/21 would be significantly reduced, and the debt ratio would not decline in the medium term.
- Fiscal sensitivity: Each 1 percentage point decline of GDP leads to about a 0.4 percentage point increase in the budget deficit.
- If Brexit disproportionately affects relatively tax-rich sectors like finance, the revenue impact could be larger.
- Reduced migration will have a negative budgetary impact (EU migrants tend to be younger and better skilled).
- Office for Budget Responsibility estimates public spending on health care and pension benefits will increase by a cumulative four percentage points of GDP between 2023 and 2043.
- Opportunities:
- Explore further efficiency gains in the NHS.
- Elimination of the “triple lock” could lead to important savings over time on pensions.
- Revenue measures will need a more prominent role in deficit reduction absent fundamental rethinking of the size and role of the public sector.
- Tax reform recommendations:
- Scale back preferential VAT rates to increase tax neutrality.
- Better align tax treatment of employees and the self-employed.
- Reduce the tax code’s bias toward debt (e.g., adopt a tax allowance for corporate equity).
- Rebalance property taxation away from transactions toward values to boost labor mobility and efficient use of housing stock.
Contingency Planning
- Under a disorderly Brexit scenario, policies should seek to safeguard macroeconomic and financial stability.
- Bank of England would need to ensure the financial system has adequate liquidity in the event of sharp declines in sterling and other asset prices.
- The implications of Brexit for monetary and fiscal policy are uncertain and depend on relative shifts of supply and demand and extent of sterling depreciation.
- Fiscal framework provides flexibility to support the economy (e.g., bringing forward infrastructure spending), but space to respond could narrow if the shock significantly raises interest rates on public debt.
- Any easing of fiscal policy should be temporary and embedded in a credible medium-term fiscal consolidation plan.
- A permanent shock to output would require an eventual adjustment of revenues or spending.
Financial Sector Policies
- Bank balance sheets have continued to improve: capital, leverage, and liquidity positions are strong.
- The countercyclical capital buffer requirement will increase to 1 percent in November.
- Bank of England’s 2017 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.
- Banks subject to ringfencing requirements are on track to meet the January 2019 deadline.
- Adoption of the MiFID II framework has strengthened investor protection and increased transparency.
- Vigilance required: relatively easy financing conditions could lead to increasing prudential risk.
- Household and corporate leverage have started to edge up, but remain below pre-crisis levels.
- Total lending is growing broadly in line with GDP.
- Consumer credit continues to rise much faster than income despite recent tightening of underwriting standards.
- Potential policy responses if high growth in consumer credit persists: additional increases in bank-specific capital buffers and enhanced oversight of nonbank financial institutions.
- Other vulnerabilities: valuation of commercial real estate (CRE) and to some extent housing; CRE prices remain high and have continued to rise after a short-lived dip following the EU referendum.
- Ratio of new mortgage loans at relatively high loan-to-income ratios has increased somewhat in the last two years, although the share of highly indebted households remains low.
- Market-based corporate borrowing has expanded rapidly, with significant foreign investment in CRE and leveraged loans.
- Authorities’ effort to collect information on leverage outside the banking system and assess potential vulnerabilities is welcome.
- FPC and Prudential Regulation Authority commitment to implement robust prudential standards to maintain financial sector resilience post-Brexit is commendable.
- Current account developments:
- Current account deficit narrowed to 3.9 percent of GDP last year (improvement over deficits of around 5 percent of GDP in recent years).
- Share of external financing that is short-term has risen, raising financing risks; associated stability risks are limited by strong capital and liquidity positions of UK banks and credible fiscal and monetary frameworks.
- Trend should be monitored, especially given rising US interest rates and concerns about UK long-term growth potential.
- Continued fiscal consolidation should help further reduce current account deficit over time.
- Proactive measures to support Brexit preparations of regulated financial institutions include preparing legislation for temporary permissions and recognition regimes to allow EEA financial services firms, funds, and central counterparties to continue activities in the UK for a time-limited period after exit.
- Regulatory and supervisory cooperation between UK and EU authorities will be crucial; a technical working group chaired by the heads of the Bank of England and the European Central Bank has been established to discuss Brexit-related risk management.
- EU and UK authorities should work together to ensure legal continuity in insurance and derivative contracts and proper data sharing to avoid cliff-edge effects.
Structural Policies
- Long-run living standards will predominantly depend on productivity growth; UK productivity levels and growth lag peer economies.
- Output growth has depended largely on increases in employment; scope for substantial future employment gains is limited (unemployment around historic lows and net immigration of workers from the EU is already falling).
- Brexit implications largely negative for productivity: reduced migration will result in less efficient matching of jobs and workers; a more closed UK economy will be less competitive and less attractive for foreign direct investment.
- Continued policy efforts are needed to support productivity, reduce income inequality, and address regional disparities.
- Inequality has declined since the crisis but remains high compared to other advanced economies; intergenerational income mobility is low.
- Regional disparities are large; UK has some of the most productive and some of the least productive regions.
- Recent initiatives:
- Introduction of T-level qualifications and the apprenticeship levy to raise job-specific and higher level technical skills and reduce regional disparities in skills provision.
- Monitor and evaluate effectiveness of these programs once established.
- A £31 billion National Productivity Investment Fund targets transport, housing, digital, and research and development investments.
- Infrastructure investment targeted to increase by over 50 percent from 2012/13 to 2020/21.
- Fiscal remit for the National Infrastructure Commission aims for sustained public infrastructure investment of 1 to 1.2 percent of GDP over the long-term.
- An expert review will examine competition challenges in the digital economy and recommend policy responses by early 2019.
- Boosting economic opportunities for women:
- Female participation rate is 74 percent.
- Recent initiatives include improving government support for childcare costs and doubling free childcare available to 3- and 4-year-olds of eligible working parents; free childcare for disadvantaged children aged 2.
- Fully closing the participation rate gap would boost output by around 5 to 6 percent in the long run.
- Policies to facilitate job sharing and compressed work schedules could help.
- Gender pay gap stands at 10 percent on average for full-time employees.
- Legislation requiring larger firms to publish gender pay gap data has focused attention on pay disparities.
- Brexit-induced structural shifts: changes in trade and migration regimes will vary across industries and regions; policies to smooth worker flows geographically and across sectors recommended, including:
- Increased use of active labor market policies and support for re-training (e.g., National Retraining Scheme).
- Policies promoting entrepreneurship.
- Higher investment in research and development.
- Reforms to promote housing supply and mobility.
- Policies should support workers and not particular jobs or sectors.
- Corporate transparency measures:
- Verification measures for the People with Significant Control (PSC) register continue to be developed and implemented.
- Financial institutions should be required to report discrepancies in the PSC register.
- Proposal for a register for foreign owners of UK real estate is welcome and should include verification measures.
- New Office for Professional Body Anti-Money Laundering Supervision expected to improve consistency of AML supervision in accountancy and legal sectors.
- Continued exchange of ownership information among UK authorities, Crown Dependencies, and British Overseas Territories is important.
Source: United Kingdom: Staff Concluding Statement of the 2018 Article IV Mission (September 17, 2018), International Monetary Fund.