United Kingdom -- 2003 Article IV Consultation, Concluding Statement of the IMF Mission
December 18, 2003
• In the face of sizable global shocks over the last few years, the performance of the U.K. economy, supported by stimulative macroeconomic policies, has been enviable.
• The external environment is now improving, and macroeconomic policies should tighten to rebalance external and domestic demand. Our growth projections are similar to those of the PBR for 2003 and 2004, but are somewhat less sanguine over the medium term.
• The main risk to this baseline relates to the effect that a sudden drop in house prices could have on consumption. This risk has been lowered by the improved monetary and fiscal frameworks introduced during the 1990s, but it cannot be discounted altogether.
• While inflation is low, we see a case for pre-emptive, gradual tightening of monetary policy as signs of recovery are confirmed. This is reinforced by the ebullience of the housing market.
• The widening fiscal deficit does not raise sustainability problems, but a gradual strengthening is needed over time.
• The PBR sees a turnaround in the public finances even in the absence of policy actions. We see significant risks to these projections. On unchanged policies, we see only a small improvement over the forecast horizon, with the deficit about 1 percentage point of GDP above the government's projections by FY 2006/07.
• Our preferred mode for achieving fiscal adjustment is by moderating the growth of spending in areas where current plans involve sharp increases, with associated risk of inefficiencies. The expenditure policy framework has been strengthened, but it is not yet clear to what extent public spending is achieving the desired results with value for money.
• A key longer term challenge is to ensure adequate provision of pensions as the population ages. We view the government's strategy of promoting voluntary private savings as appropriate. But the performance of this strategy will need to be assessed periodically and we welcome the creation of the independent Pension Commission that has been charged with this task.
We would like to thank the authorities and other participants for their cooperation in meetings with IMF staff during December 4-18. The work of the mission has been greatly facilitated by the excellent quality of the policy documents published by the authorities, including the Pre-Budget Report and associated publications, the Inflation Report, and the Financial Stability Review.
1. In the face of sizable global shocks over the last few years, the economic performance of the United Kingdom has been enviable: growth has been resilient; investment has remained above its historical average in relation to GDP; unemployment has been stable at a low level; and inflation has remained close to target. The economy's strength has reflected the buoyancy of domestic demand, supported by stimulative macroeconomic policies.
2. The external environment is now improving. Over time, domestic demand will need to make room for the pick up of external demand, and monetary and fiscal policies will need to tighten to facilitate this rebalancing. Continued robust increases in house prices and household debt, which have supported private consumption in recent years, make the timing, speed and composition of the required policy tightening a particular challenge at this juncture. Substantial longer-term challenges also persist: closing the productivity gap with other industrial countries, ensuring the provision of adequate pensions as the population ages, and reducing the amplitude of house price cycles.
Rebalancing Growth: The Outlook
3. Leading indicators suggest an imminent acceleration in growth above the near-trend rates of the second and third quarters. Consumption is projected to strengthen through early 2004, supported by further rises in house and equity prices, and a pick up in disposable income. But, as house valuations become more stretched, house prices are expected to decelerate. This, together with rising interest rates, is likely to slow down consumption during 2004. Our baseline assumes this happens gradually. With corporate leverage close to historic highs, a need to close pension deficits, and an investment-to-GDP ratio still above historical averages, we project business investment to gather pace only gradually. Overall, we forecast GDP growth to rise from about 2 percent in 2003 to 3 percent in 2004, before settling down to its trend rate of slightly above 2½ percent.
4. In the near term, we see upside risks on the domestic front. Continued strong house and equity price increases may boost consumption. Investment could also surprise on the upside if the global capital expenditure cycle reverts to historical recovery patterns. On the external front, the risks remain on the downside, as recovery in the euro-area may be delayed by further depreciation of the dollar. Beyond the near term, the main risk relates to an abrupt adjustment of house prices and household balance sheets, with possibly protracted effects on consumption. Assessing the likelihood of such a hard landing scenario is difficult, inter alia because of limited knowledge on the current distribution of assets and liabilities across households. The risk of interactions between the house price and the economic cycles, which have featured prominently in U.K. economic history, has been lowered by the improved monetary and fiscal frameworks, but it cannot be discounted altogether.
The Role of Monetary Policy
5. The monetary policy framework has achieved a high degree of credibility, as underscored by the stability of inflation expectations around the symmetric inflation target. Against clear indications of the cyclical recovery, the increase in policy interest rates in early November was fully appropriate.
6. Looking ahead, monetary policy will have to be framed in the context of the new CPI inflation target. While CPI inflation is currently significantly below target, monetary policy should remain forward looking and tighten as signs of recovery are confirmed. First, the slowdown in growth has been modest, and unemployment has remained at a multi-decade low. This suggests a limited build-up of slack. Earnings have surprised negatively, but this reflects in part the impact of improved terms of trade on real product wages. Altogether, we gauge the output gap at around ¾ percent of GDP in the third quarter, closing under the baseline by mid-2004. Second, imported inflation, recently muted, is bound to rise with the global recovery and from pass-through of sterling's earlier depreciation. Finally, the case for tightening is reinforced by the ebullience of the housing and household debt markets. Turning to the speed and timing of interest rate increases, the potentially higher sensitivity of the debt servicing burden to interest rate changes (reflecting higher debt levels) suggests that a gradual but early tightening of monetary policy is the best means for achieving a soft landing in consumption and the housing market.
7. In the Inflation Report, the Monetary Policy Committee has employed inflation projections at a two-year horizon to help explain its interest rate decisions. This has the advantage of simplicity and is consistent with the more limited impact of monetary policy at shorter term horizons. However, discussing inflation forecasts running further out could on occasion better illustrate the rationale behind certain monetary policy decisions. This includes the appropriate response, in an inflation targeting framework, to asset price bubbles, whose implications go beyond the standard two-year horizon. Such an approach would also be consistent with the Bank of England's remit that requires inflation to be kept at 2 percent at all times.
Fiscal Policy Prospects
8. The public finances have swung sharply, turning from a surplus of 1½ percent of GDP in FY 2000-01 to a projected deficit of 3½ percent in FY 2003-04. This weakening has mostly reflected planned increases in spending and unexpected shortfalls in revenues. The latter underperformed not only for cyclical reasons, but also because of factors unrelated to the economic cycle—primarily a drop in taxes from financial sector activities since the bursting of the global equity market bubble and, more recently, lower-than-expected earnings growth. The Pre-Budget Report (PBR) projections imply that the fiscal accounts will have underperformed budget targets for a third consecutive year. In cyclically-adjusted terms, the extent of the fiscal underperformance has been particularly marked this fiscal year, with the deficit being revised up by almost 1 percent of GDP only six months after the budget, though this is partly due to larger-than-expected spending on security.
9. The widening of the deficit has played a useful countercyclical role, and public debt remains at a low level. Nevertheless, a gradual decline in the deficit is now appropriate. This is not only to meet the fiscal rules, but also for broader reasons: strengthening fiscal fundamentals (at present the cyclically-adjusted primary balance is in deficit involving, over time, a rising stock of debt); and reducing the burden and risks for monetary policy by limiting the interest rate increases and thus lowering the risk of a hard landing of house prices. We favor bringing the deficit to 1-1½ percent of GDP over the medium term. Outcomes at the upper end of the range would allow the public debt-to-GDP ratio to stabilize at about 35 percent, leaving room to accommodate shocks under the sustainable investment rule. A lower deficit would provide more comfort against potential contingent liabilities (including those from population aging; see below), and leave greater room for private investment. As to the timing and pace of the adjustment, given the cyclical position of the economy, adjustment should begin in the 2004 budget. A decline of about ½ percentage point of GDP in the cyclically-adjusted deficit would provide the right signal of a change in course.
10. The PBR does project a steady turnaround in public finances starting in FY 2004-05, with the deficit declining to 1¾ percent by FY 2008-9. In FY 2004-05 the cyclically adjusted deficit would decline by 0.4 percentage point of GDP. This adjustment path is somewhat less ambitious than in our preferred fiscal adjustment scenario, described in the previous paragraph. But, more importantly, the authorities' adjustment is not based on new policy actions. It primarily reflects the cyclical upturn, a rebound of revenues from the financial sector, improved collection efficiency, and a rise in effective tax rates due to the fiscal drag (from uprating tax thresholds with prices rather than earnings). We are more pessimistic. In our view, in the absence of actions, the deficit would decline only modestly over the medium term—to about 2¾ percent of GDP in FY 2008-09. In this scenario, the risk of breaching the golden rule in the current cycle is not trivial. These less sanguine projections reflect two factors. First, our estimate of the current output gap is lower, implying a more modest cyclical rebound in growth and revenues over the medium term. Second, we project a more contained recovery of tax revenues from financial sector activities, as we view tax yields in the late 1990s as boosted by the global equity market bubble. There is, of course, considerable uncertainty about these developments. But it will be important not to delay action in the event deficit outturns appear bound to exceed official projections. The existence of well established fiscal rules should reduce the risk of such an outcome.
11. Our preferred mode for achieving fiscal adjustment is by moderating the growth of spending in areas where current plans involve sharp increases in the immediate future, with associated risk of inefficiencies. The authorities have strengthened the expenditure policy framework in recent years to reduce this risk, but it is not yet clear to what extent public spending is achieving the desired results with value for money. We accept that measurement problems likely understate the improvements in quality of public services on a national accounts basis. Thus, we welcome the initiative launched by the National Statistician to improve the measurement of output in public services. But continuing increases in indicators of public sector costs, particularly in areas such as transportation, where measurement problems are less significant, would be a cause for concern as they could indicate supply bottlenecks. A wider application of user fees to fund public services (including university fees, road charges, and levies on the use of health services) would help both in achieving fiscal savings and in reducing inefficiencies. If adjustments are to be made on the revenue side, we would argue for broadening tax bases rather than for raising tax rates.
12. We welcome the assessment of the five tests, which clarifies the government's position on euro adoption. The comprehensive analysis carried out by Treasury makes an important contribution to informing the public debate on the economic benefits and costs of EMU entry. The reforms that the government is introducing or is considering in order to increase convergence with the euro area and economic flexibility are warranted in their own right, as the authorities have underscored. In this respect, we welcome the interim reports of the Miles and Barker reviews on improving the functioning of the housing market.
Structural and Financial Sector Issues
13. A key challenge is to ensure adequate provision of pensions as the population ages. Rising longevity and the drop in equity markets have caused some employers to re-evaluate their pension provision, with many defined-benefit schemes switching to defined contribution. Ultimately, for the state to avoid contingent pension liabilities, it is critical that the private sector save sufficiently. To that end, we view the government's strategy of promoting voluntary private savings for retirement as appropriate. But a flexible proactive approach that assesses the performance of this strategy and changes course if needed will have to be maintained. In this regard, we welcome the creation of the independent Pension Commission and look forward to its interim report and final recommendations.
14. As discussed in past consultations, the productivity gap with leading developed countries remains substantial. Given the incomplete state of knowledge on the causes of this gap, the government has appropriately taken a multi-pronged approach with numerous initiatives on all the key drivers of productivity: competition, enterprise, science and innovation, skills, and investment. While we welcome the recent reforms and initiatives for new programs in these areas, there is a need for systematic monitoring and evaluation of ongoing initiatives. This would allow for the retirement of unsuccessful initiatives, the extension of successful ones, and a targeted prioritization over time. We are encouraged by the success of some of the New Deal active labor market programs, particularly those aiming to foster the integration of 18-24 year olds into the labor market. This augurs well for the extension of this approach to the 25+ year old through the new pilot programs announced in the PBR. The effectiveness of other programs, however, remains to be demonstrated.
15. In the financial sector, bank profitability and capitalization remain strong. Going forward, the mix of risks will evolve with changes in the macroeconomic environment. In particular, banks will need to adjust to higher interest rates in the context of persistent uncertainty on housing and commercial property price developments. The compression of margins from increased competition could be a drag on profitability over the medium term as credit growth decelerates. Although conditions in the life insurance industry have stabilized with increases in stock prices and improvements in capitalization, some weaknesses remain. The ongoing reform of insurance regulation by the FSA will strengthen the sector and reduce the risks of systemic stress in the future. We also welcome the recent reforms to the payment and settlement systems, which have significantly enhanced their efficiency and further reduced settlement risk.