United Kingdom -- 2001 IMF Article IV Consultation, Concluding Statement of the Mission
December 11, 2001
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
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United Kingdom--2001 Article IV Consultation
Concluding Statement of the Mission
1. The current nine-year expansion marks the longest period of sustained noninflationary growth of the U.K. economy in more than 30 years. Output has increased by an average of 3 percent per year during 1993-2000, inflation has remained subdued, and unemployment is now at its lowest level in a quarter century. While activity has decelerated with the slowdown in world demand, this year the U.K. will grow faster than any other G-7 country.
2. This remarkable performance owes much to the government's strong policy framework. This framework, through its emphasis on clarity of objectives, transparency, and accountability, has fostered policies that have been at once predictable and responsive to changing economic circumstances. Under the guidance of the two fiscal rules, public finances have been strengthened, with the public debt ratio falling rapidly. The symmetric inflation targeting framework has enabled the Monetary Policy Committee (MPC) to respond promptly to demand shocks, including the recent global slowdown. Finally, important structural reforms are underway, enhancing the prospects for continued strong performance over the medium term.
3. But challenges and risks remain. The weaker external demand environment and the persistent strength of sterling are hampering the manufacturing sector. Moreover, other developments (the high level of private debt, the prolonged rise in house prices), while possibly structural, might also be symptomatic of underlying imbalances. Such imbalances could increase uncertainty regarding the impact of policies and, if they reversed abruptly, could hinder macroeconomic performance. Against this background, the recent Pre-Budget Report (PBR) projects GDP growth at 2-2½ percent in 2002. This range is only slightly above our central forecast, but the uncertainty surrounding these figures is larger than usual. Over the medium term, the key challenge will be to raise productivity, including through the provision of better public services. Whether these challenges are met successfully will depend, in no small measure, upon the design of economic policies.
A Prudent and Predictable Fiscal Policy
4. Fiscal policy should continue to meet the high standards of prudence and predictability that have characterized it over the last few years. The outlook for the fiscal balances in the recent PBR meets these standards. In terms of prudence, cyclically-adjusted overall deficits of about 1 percent of GDP over the medium term would not compromise the strong underlying fiscal position achieved in the late 1990s, as highlighted by the projected stability of the public debt ratio at the modest level of 31 percent of GDP. In terms of predictability, the deviation of the fiscal balances over the next three fiscal years from the projected path in the 2001 budget is not large, and reflects primarily factors that, while not strictly cyclical, are thought to be temporary. At the same time, the fiscal stance will support monetary policy, given the spending increases already envisaged in the 2001 budget and the allowance that the current fiscal framework makes for the operation of the automatic stabilizers.
5. We do not see much room for raising the deficit above the path projected in the PBR. In particular, the PBR deficit path does not include certain measures that are yet to be decided or costed, nor, naturally, does it reflect the outcome of the 2002 spending review. If such measures were introduced, or if spending were raised beyond the amounts envisaged in the PBR, offsetting measures should be taken. There are reasons for being prudent. First, large discretionary deviations from the previously announced deficit path would not be consistent with the policy predictability that remains key to maintaining confidence. Second, revenue prospects are uncertain: the buoyancy of tax receipts in the last few years is partly unexplained and, thus, the revenue shortfall this year may not prove as temporary as expected. Third, sizeable fiscal impulses are already envisaged in the period ahead and, while there are downside risks to the macroeconomic outlook, there are also upside risks (see below). Further expansionary fiscal measures may later require a sharper increase in interest rates, with undesirable consequences for private investment, and, possibly, the exchange rate.
6. Over and above the issue of the appropriate size of the fiscal deficit, the policy debate has recently refocused on whether it would be appropriate to raise taxes to finance public spending beyond the amounts envisaged in the PBR outlook. Again, we would call for caution. Additional spending increases should be undertaken only if clear-cut economic justification can be found and in the context of reforms to raise spending efficiency. But, even in this case, the speed at which certain expenditure targets should be reached needs to be examined in light of the already rapid acceleration of spending envisaged in the PBR: primary spending is projected to rise by a cumulative 16 percent in real terms in the current and subsequent two fiscal years. A faster pace, or a continuation of expenditure growth well above GDP growth in the following years, may be difficult to implement without incurring significant waste, although the ongoing strengthening of the expenditure management framework-as well as the authorities' intention to allow the private sector to play a larger role in providing public services-should help in this regard.
7. Should a strong case for additional spending be found, which taxes ought to be raised? Two principles are worth bearing in mind. First, it would be preferable to focus on measures that broaden the tax base, rather than increase tax rates (or introduce new taxes), in order to safeguard-and indeed improve-the relative neutrality of the U.K.'s tax system. Second, a broader scope for user fees would promote the efficient use of resources in the economy. In both cases, targeted transfers could offset any resulting decline in the purchasing power of the poor.
8. Turning to the overall fiscal framework, there may be ways to further enhance its predictability and transparency. The sharp fall in the public debt ratio over the last few years has reduced the relevance of the current debt ceiling (40 percent of GDP) under the sustainable investment rule as an anchor for the fiscal deficit path. One possible way to improve fiscal predictability-short of specific commitments on medium-term fiscal deficit targets-would be to lower the debt ceiling towards the current debt ratio. Such a step would help cement public confidence in a prudent deficit profile, particularly if new spending increases were to be announced. On transparency, the budget and prebudget reports, as well as the frequent consultations between the government and the public, in many respects set an international standard of best practice. Public understanding of fiscal developments might be increased further by the publication of quarterly Treasury reports explaining developments in revenue and expenditure, including in relation to budget projections.
A Flexible Monetary Policy within a Transparent Framework
9. Monetary policy has been managed adroitly within the credible and transparent framework introduced in 1997. The rate cuts since February have bolstered consumer confidence against a background of slowing global demand and declining manufacturing output. Looking ahead, we see both upside and downside risks to the outlook. With regard to upside risks, the U.K.'s cyclical position is currently not nearly as weak as those of the United States and the euro area. Moreover, while labor market indicators have weakened, unit labor costs have picked up, and house prices and credit to households remain on the rise. If consumer demand fails to slowdown as anticipated, interest rates may need to be raised promptly. On the other hand, if private demand decelerates more sharply than expected, or if the global slowdown turns out to be deeper than anticipated, a further monetary easing would be warranted. Any such easing would have to be mindful of the risk that potential imbalances in the economy-particularly the high levels of household and corporate debt-could be exacerbated. More generally, such imbalances may make it inherently more difficult to gauge the impact on the economy of a rapid rise in interest rates.
Policies for a Strong Financial Sector
10. The assumption by the Financial Services Authority (FSA) of full powers as the single regulator for financial services on December 1, 2001 completes a critical phase in the ongoing process of regulatory reform. In this regard, the FSA's project to consolidate all sectoral regulations in a single Handbook should enhance the comprehensiveness, consistency, and effectiveness of its prudential policies and minimize opportunities for regulatory arbitrage. We also support the strengthening of the U.K.'s anti-money laundering rules, which are considered, in many respects, an international model by the FATF. The financial stability and policy framework of the U.K. will be scrutinized by a Financial Sector Assessment Program which will provide an input to next year's Article IV consultation.
11. The domestic banking sector, with its high levels of profitability and capitalization, is regarded as sound by both the authorities and the markets. Looking forward, the current slowdown in economic activity, coupled with high levels of household and corporate debt, will require the authorities' vigilance to ensure that capital and provisioning remain adequate. While the U.K. insurance sector has been strained by the events of September 11, as well as by lower interest rates and stock prices, it is considered, on the whole, to be stable by regulators and market analysts alike. Nevertheless, close monitoring is essential. In this context, we welcome the FSA's plan to revise the insurance regulatory framework with a view to bolstering solvency, transparency, and consumer protection.
Structural Policies for Growth
12. Increasing the potential for growth requires not only a stable macroeconomic framework and adequate public services, but also structural policies to raise productivity, labor supply, and saving. The government's strategy in this area-providing a level playing field for market forces to operate, while at the same time focusing public sector interventions on areas of specific market failures-is appropriate. In this respect, a number of measures have recently been put forward for discussion.
13. Regarding measures aimed at raising productivity, we welcome the proposal to give full independence to the competition authorities and to strengthen the powers of the Competition Commission. We also look forward to the Commission's report on banking services to small- and medium-sized businesses. Product market efficiency, particularly in the retail sector, could benefit from the relaxation of land use regulations that inhibit competition. The proposed R&D credit for large companies should help promote innovation. In view of the evidence that the U.K. lags other major industrial countries in lower-intermediate workforce skills, we support the priority placed on improving basic and level 2 skills among adults.
14. Higher labor market participation should raise the growth potential both directly and-to the extent that it helps break intergenerational patterns of joblessness, poverty, and low skills-by enhancing productivity growth over the longer term. The New Deal programs appear to be having positive effects on the labor force participation of the young and lone parents; obtaining further lasting reductions in unemployment among the over-25 age group may prove more challenging. The Working Tax Credit (WTC) should improve in-work earnings of low-income groups. Linking the housing benefits of the working-age population to job search and integrating them with the WTC would further help increase work incentives. We welcome the efforts to reduce poverty, particularly among children and pensioners. The integration of the different child support schemes into the Child Tax Credit should help increase the take-up, and ultimately the effectiveness, of these benefits.
15. Regarding policies to promote saving, there may be a case for streamlining the plethora of different saving schemes currently available. While, in principle, there may be a case for tailoring saving vehicles to address the needs of different socio-economic groups, an excessively complex range of choices could be counterproductive. With regard to proposed new saving vehicles, we support the decision to assess carefully the effectiveness of the Saving Gateway through pilot projects: the viability of this initiative both in terms of effective targeting and its openness to abuse remains in doubt. The merits of introducing the Child Trust Fund should also be closely scrutinized in light of the risks that it might displace saving and reduce the attractiveness of Individual Savings Accounts.
The U.K. and EMU
16. Whether the U.K. should join EMU obviously remains a critical issue from both a macroeconomic and a structural standpoint. As noted in the past, the five tests set by the government are broadly consistent with the economic considerations that are relevant for assessing entry into a monetary union. The government's policy of continuing to prepare for entry, should a decision to join be made at a future date, remains appropriate.
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17. In sum, while significant risks remain, the government's policy framework seems adequate to maintain the U.K. economy on a steady course. Monetary policy, firmly anchored to the symmetric inflation target, should remain the preferred tool for responding to changes in short-term prospects. Fiscal policy should remain oriented towards prudent medium-term objectives, while allowing the automatic stabilizers to operate. Equally important, the government's structural reform agenda should continue to be pursued vigorously. The track record of sound policy design and implementation in recent years bodes well for continued success in a more uncertain world economy.