United Kingdom -- 2004 Article IV Consultation, Concluding Statement of the IMF Mission
December 21, 2004
This document contains the conclusions of the IMF mission that visited the United Kingdom during December 8-20. We would like to thank the authorities and other participants for their cooperation. Our work has been greatly facilitated by the excellent quality of the official policy documents, including the Pre-Budget Report and associated publications, the Inflation Report, and the Financial Stability Review.
1. Economic performance in the United Kingdom remains impressive. Now in the sixth year of a cycle that has seen both shallow fluctuations in output growth and robust expansion, the economy continues to be supported by resilient domestic demand and output growth. This success owes much to strong institutions underpinned by clear and well-designed policy frameworks that have helped sustain stability and anchor expectations through a global economic and equity cycle, a sizeable countercyclical policy stimulus, and a sharp increase in housing prices. Ensuring that policies continue to support strong performance is critical, and our discussions have focused on this objective.
2. The outlook is favorable, with the pace of activity likely to moderate toward a sustainable rate. We expect domestic demand to remain the driver as GDP growth slows to about 2½-2¾ percent through 2005-06. Private consumption growth is projected to fall modestly as house prices decline slightly and effective borrowing rates catch up with past increases in the policy interest rate. Continued strong earnings growth, however, should contain weakness from these sources. Business investment is projected to gather pace on the back of recent and prospective business profits. We expect the drag from net exports to fall only slightly, as the trade deficit rises. With the economy operating in the neighborhood of full capacity, a projected pick-up in import prices is expected to push the CPI inflation rate toward the target of 2 percent.
3. Risks to these projections are balanced for growth and on the downside for inflation, but—more importantly—overall uncertainties remain large. Three near-term uncertainties warrant particular attention. First, resolution of the widely perceived overvaluation of house prices and its implications for private consumption are major uncertainties, with the balance of risks for both activity and inflation probably on the downside. Second, the global environment—particularly with respect to foreign demand and exchange rates—presents major, but probably also downside risks. Third, traditional yardsticks of resource constraints appear to be breaking down: productivity growth has recently exceeded expectations and the unemployment rate consistent with low inflation has fallen. The balance of risks for aggregate supply is on the upside. Nevertheless, testing possibly new supply-side limits must be done with sufficient caution to avoid costly mistakes.
4. Over the medium term, uncertainties center around more structural dimensions of the economy. Considerable uncertainty about the course of revenues over the medium term has heightened the debate about whether current policies will return the fiscal accounts to a sustainable position consistent with the government's fiscal rules. Should recent trends in the trade deficit not stabilize as we expect, implications for the valuation of sterling must be carefully monitored. And questions about the adequacy of private saving to support the aging population need to be resolved. The combination of near- and medium-term risks argues for policy settings that situate the economy comfortably to withstand worse than baseline outcomes.
5. During the past year, monetary policy has adroitly responded to the balance of emerging risks. Increases in interest rates appear to have been effective in preempting the emergence of excess demand and, in so doing, helping to cool the housing market. More recently, with interest rates once again in a broadly neutral range and signs of easing demand growth, interest rates have appropriately been held constant.
6. In these circumstances, monetary policy is well-positioned to respond in either direction should short-term risks materialize. The macroeconomic impact of house price developments will likely remain a challenge for interest rate decisions. Our central projection of a modest decline in house prices would require little response from policy. However, we believe that more pronounced changes in either direction could have significant effects on consumption, activity and future inflation, and would warrant decisive policy action. Another challenge for monetary policy will be judging incipient resource constraints. Although a sharp drop in unemployment would point to the need to tighten, a gradual edging down would be more difficult to interpret. At a time when years of structural and macroeconomic policy improvements may boost the sustainable level of output, it will be important to probe limits, but to do so cautiously: risks of missing warning signs could be costly.
7. The recent success of monetary policy stems in no small part from a strong policy and institutional framework. Credibility is underpinned by the success in achieving low and stable inflation and is reflected in well-anchored expectations. As a testament to the solidity of the framework, the shift from an RPIX to a CPI target—which effectively raised the inflation target by about ¼ percentage point—was well communicated to and well understood by financial markets. Commendably, the implementation of monetary policy within the framework continues to evolve, as evidenced by the Bank of England's proposed voluntary reserve system that should lead to less volatility in overnight interest rates. Also, over the past year, welcome changes have been made in the ways the Bank of England communicates its decisions to markets: the increased emphasis on the use of market expectations of future interest rates for the inflation projection and the extension of the horizon of the projection from two to three years add to the public understanding of interest rate decisions. To move further in this direction, the Bank of England should consider expanding the number of key macroeconomic variables for which quantified projections are provided.
8. The fiscal position deteriorated substantially in recent years, and questions are emerging about how and when the necessary correction will take place. Despite the recent history of optimistic revenue projections, the PBR projects that revenues relative to GDP will rise over the medium term to close to the peak ratio at the turn of the century, while expenditure growth will slow sharply after FY2005/06. If these projections are realized, the net borrowing requirement will fall to 1½ percent of GDP over the medium term-the level consistent with stabilizing net debt below 40 percent of GDP. Our central forecast, however, is for lower revenue growth, reflecting mainly slower real GDP growth in 2005 and a less pronounced rebound of corporation tax revenue over the medium term. On these projections, the net borrowing requirement will fall only to 2½ percent of GDP and measures to close the gap vis-à-vis the PBR forecast will be needed.
9. Moving ahead expeditiously with this mild fiscal adjustment is desirable from a number of perspectives. First, it would allow the consolidation to be spread more smoothly over time. Second, it would take advantage of the present strong economic outlook to begin the adjustment when its impact on the economy is most easily absorbed. In this vein we would note that the FY2005/06 fiscal projections outlined in the PBR actually envisages a small one-off increase in the structural deficit. Third, early adjustment would significantly reinforce the credibility of the fiscal rules. Specifically, although it seems likely that both fiscal rules will be met in the current cycle, without early adjustment, a relatively weak initial current balance in the next cycle could weaken confidence in the rules. Fourth, adjustment would help build the buffer needed to weather adverse shocks.
10. The design of the adjustment measures should minimize any adverse effects on efficiency, work effort, and growth. We would favor an approach that relies on spending restraint—both to reduce the current risks of running into limits on absorptive capacity and to allow more time to assess value for money. Also, wider application of user fees would raise efficiency and revenue. If more reliance on revenue measures were desired, broadening the tax base would be preferable to raising tax rates, given potential adverse effects on supply.
11. Within a fiscal policy framework that is at the forefront of international best practice, it will be worthwhile to review the operation of the fiscal rules as the cycle comes to a close. Reflecting on the experience of the present cycle, we would urge consideration of possible modifications in two areas. The first concerns how prudence in meeting the fiscal rules is built into the budget. At present, the budget projections are sprinkled with cautious assumptions—on the trend growth rate, the elasticity of VAT revenue, the AME margin, to name a few. To increase transparency of the overall degree of prudence, the projections could be based on central assumptions, with caution expressed as an explicit contingency reserve in the budget, and the uncertainty surrounding the key variables shown explicitly. The second concerns the reach of independent assessment. Several assumptions underlying the projections are now audited for reasonableness by the National Audit Office. It would be worth considering whether such outside scrutiny of other key variables would enhance transparency and credibility.
12. The efficiency of spending and revenue collection needs to remain under close review. Quantitative targets to help monitor public services are welcome, though we remain concerned that large spending increases could jeopardize cost effectiveness. The new efficiency targets, which will be monitored by a new efficiency unit, aim among other things to improve procurement and increase the flexibility of work practices. However, we would caution that there are inherent challenges in measuring outputs, including linking policies to targets, measuring quality, and avoiding resource diversion. On revenues, we welcome the planned integration of Inland Revenue and Customs, which is critical for improving tax collection and using information better.
Financial Sector and Structural Policy Issues
13. The overall position of the financial sector remains favorable. Bank capitalization, credit quality, and profitability continue to be strong. However, slower credit growth will likely dampen profitability and there are some downside risks, including from unsecured lending to households, lending related to commercial property, and the ongoing search for yield. The health of the life insurance sector has improved substantially over the past year, partly reflecting increases in equity prices. The resilience of the financial sector is being enhanced by the introduction by the Financial Services Authority (FSA) of risk-based capital measures in insurance firms, the FSA's introduction of broker regulation in the nonlife insurance sector, and the strengthening of the supervisory and institutional aspects of payments and settlement systems by the Bank of England.
14. A critical debate about the government's role in ensuring adequate retirement income over the long term is underway. The Interim Report of the Pensions Commission provides an excellent analysis of the challenges and sets out possible directions for policies. The report provides strong evidence that at least some people are unlikely to be saving enough to ensure a level of retirement income that meets their aspirations. The appropriate role of government in addressing this problem is not obvious: it depends crucially on the tradeoff between the risk of forcing some people to save more than they wish and the risk of some people not saving enough and falling back on the government in the future. Nevertheless, actions to reduce the need for saving would seem sensible—in particular by further increasing pensionable ages as life expectancy continues to rise and greater flexibility for people to trade off working longer for higher pensions. More generally, the solution to the saving problem should be clearly sustainable over the long run, reduce the complexity of the current system, and provide the right incentives to work and save.
15. Remaining concerns about the housing market make further progress in implementing the recommendations of the Miles and Barker Reviews crucial. To facilitate the development of a longer-term fixed-rate mortgage market, the Miles Review recommended improving the advice and information that borrowers receive and creating a fairer and more transparent pricing structure. Various measures have already been implemented, including legislative action to remove the future constraint on the ability of building societies to securitize assets as a source of funding. Looking ahead, it is important that the FSA incorporate the Miles recommendations in its forthcoming review of the statutory regime for mortgage lending. To improve housing supply, the Barker Review recommended increasing the role of price signals and reducing delays in the planning process. It is important that these general recommendations be formulated into concrete legislative proposals.
16. Labor productivity growth in the United Kingdom over the past decade has been higher than the average in other G7 countries, but the level is still about 10 percent lower. As the gap is due to a variety of factors, the relative importance of which is unclear, the government's multi-pronged strategy is appropriate. The systematic monitoring and evaluation of ongoing programs is essential, and the recent introduction of specific performance indicators will help in this respect. Regarding the incapacity benefit, policy measures to moderate inflows have been successful, and recent innovative efforts to use active labor market policies to help benefit recipients move into work are welcome.
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17. The U.K. economy remains strong and stable. Monetary policy is well-positioned to respond to the range of risks that appear most likely in the near term. Fiscal policy is bound by well-constructed rules to which the authorities have reaffirmed their commitment. The financial sector remains under close and competent scrutiny. Structural policy initiatives continue to strive for improvements in efficiency and productivity. While the benefits of flexibility and macroeconomic stability are likely to grow over time, there are risks and policymakers need to remain vigilant.