United Kingdom -- 2006 Article IV Consultation, Concluding Statement of the IMF Mission
December 18, 2006
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.
This year, there has been a relatively high convergence between our and the authorities' views on central projections for the economy for the near and medium terms, and related demands on macroeconomic policies. Given this agreement, good structural policies, and the IMF's efforts to better focus surveillance, we have centered our discussions on the risks—upside and downside—to the UK economy from globalization. This statement, which experiments with a new format, covers the central outlook briefly before turning to this risk assessment.
1. Macroeconomic performance in the United Kingdom remains impressive. The growth of investment, productivity, and output has rebounded from a softer 2005. Net immigration has spurred capacity growth, though inflation has risen and the current account deficit has widened slightly. Macroeconomic policy frameworks are supportive: they have contributed to the good performance and are guiding policies in ways that are responsive to the requirements for strong growth with low inflation. Financial markets too have performed well: London continues to grow as a global financial center with sound institutions and a good record of supervision. The near- and medium-term outlook is for continued strong and stable growth with a return of inflation to target.
2. Given this benign outlook, much of our discussion has reviewed how well macroeconomic policies place the economy to respond to shocks. Openness and flexibility, reflecting in part the wide-ranging structural reforms undertaken over the last two decades, have paved the way for enormous benefits from globalization, which has played to the strengths of the UK economy. Alongside such benefits, economies need to be prepared to weather any downside developments. For the United Kingdom, flexibility and sound macro frameworks are key shock absorbers. It is important also that fiscal and monetary policies are positioned to respond effectively. This means that public debt must be kept at moderate levels, in line with the fiscal framework; monetary policy must disentangle and respond to the wider variety of factors now driving inflation; and thorough and effective supervision of the financial system must be maintained. On the whole, we are reassured by our discussions, though we believe that efforts to increase margins for responding to adverse developments need to be sustained, particularly in the current favorable conjunctural conditions.
Policy challenges in a strong growth environment
3. GDP growth picked up in 2006 and is expected to remain robust. We see growth at about 2¾ percent in each of the next two years, broadly in line with potential and close to the forecasts in the Pre-Budget Report and the latest Inflation Report. Business investment is being boosted by healthy corporate balance sheets and the low cost of capital. Solid growth of private consumption is based on rapid employment growth and generally strong household balance sheets. The external current account deficit should be stable, as the sizable deficit on trade in goods and services continues to be partly offset by strong net investment income. The unemployment rate has risen, but we expect this to be temporary as the dampening effect on labor demand from higher energy costs dissipates and the recent surge in new entrants to the labor force is absorbed. Over the medium term, immigration is expected to boost growth, through both the direct effect on labor supply and the need to equip new workers with capital.
4. Consistent with this favorable outlook, financial sector prospects are strong. Net exports of financial services have risen steadily over the past decade and increased sharply in recent years. UK banks are among the most profitable in the G7 and ratings agencies rank the UK banking system as one of the strongest in the world. The strength of the banking system reflects effective financial regulation and supervision in the context of improved risk management, geographical diversification, and the growth of new business activities. In particular, the development of financial markets has allowed banks to transfer some of the risk that they traditionally held on their own balance sheets. The insurance sector has returned to a more stable outlook. And the ongoing shift from negotiated, bilateral banking finance to arms-length finance through asset markets has facilitated consumption smoothing.
5. In an environment of healthy growth, taming the energy-price-related increase in inflation remains a challenge. With energy prices now expected to be permanently higher than they were a couple years ago, full adjustment to them—via a temporary slowing in real wage growth to rebuild the profit margins of firms using energy inputs—is inescapable. Some of the adjustment has occurred; the sooner it is fully realized, the sooner inflation will return to target and the more robust will be economic performance. Yet, with diminishing economic slack and possibly rising inflation expectations, incentives to achieve this adjustment are weakening. The gentle tightening of monetary policy in recent months has therefore been appropriate to help ensure that inflation returns to target, as we expect, over the coming year. For the immediate future, continuing to communicate the importance of wage restraint will help minimize the need for increases in interest rates. Depending on evolving prospects for wage growth, some further tightening of monetary policy may be needed.
6. Continued fiscal restraint is also essential given the still sizable overall deficit. The strong macroeconomic outlook provides a favorable environment for it. Following the substantial fiscal adjustment in 2005/06, we expect a further modest narrowing of the overall deficit relative to GDP in 2006/07. After the sharp increase in spending during 2002/03-2005/06, the targeted slowing this year is welcome. However, the spending pattern thus far means strong discipline through the remainder of the year is needed. With the overall deficit close to 3 percent of GDP, the Pre-Budget Report contains plans for the further adjustment needed to halt, in the medium term, the rise in net debt as a share of GDP. We broadly agree with the Treasury that tax buoyancy alone should result in a modest increase in revenue relative to GDP. Also, we strongly support the government's plans to first stabilize and then lower spending as a share of GDP. This will require tough choices in the Comprehensive Spending Review, particularly as important infrastructure needs argue for maintaining capital spending as a share of GDP at its present level. With the implementation of these plans, we expect the overall deficit to decline gradually to 1½ percent of GDP by 2011/12, a level consistent with maintaining debt below 40 percent of GDP and only slightly higher than the forecast in the Pre-Budget Report. We welcome the proposed pension reform to address the long-term challenges of the pension system without jeopardizing fiscal sustainability.
7. The fiscal framework is supporting the improvement in public finances. The fiscal rules—the sustainable investment rule and the golden rule—have helped to constrain discretion and protect investment. Continuing commitment to the framework during the prospective period of strong growth will help ensure that good times are indeed used to reduce the underlying fiscal deficit. As experience grows, further improvements to strengthen the framework should be considered. An important pillar of the framework is the auditing by the National Audit Office of certain key assumptions underpinning the fiscal projections. Broadening the reach of this auditing process would further enhance confidence in the fiscal projections. And, once current balance is regained, consideration should be given to alternative formulations of the golden rule that preserve its constraint on discretion and fit likely future circumstances.
Positioning the economy to respond to global and domestic shocks
8. Ensuring that the economy can take advantage of upside opportunities for growth and weather downside developments lies at the heart of good policymaking. For even as remarkably strong world economic conditions persist, global and domestic risks are sizable. These create a great deal of uncertainty on both sides of our projections. On the upside, immigration may be expanding the economy's productive capacity more quickly than is currently envisaged, which would lead to higher growth. Three other low-probability but potentially high-impact risks are important at the present juncture. First, a disorderly adjustment of the US dollar could put upward pressure on sterling, leading to a further widening of the UK current account deficit. Second, a global reassessment of risk could trigger a sharp increase in interest rates. This could cause, among other disruptions, a decline in UK property prices. Third, notably slower-than-envisaged global growth would adversely impact the UK economy.
9. Openness and flexibility continue to position the United Kingdom to benefit from the opportunities of globalization and absorb shocks. The recent rapid growth of the world economy has boosted demand for exports, especially of financial services, and allowed the United Kingdom to source goods from the lowest cost global producers. The combination of benign global financial conditions and openness to capital flows has contributed to record levels of foreign direct investment inflows, while allowing the United Kingdom to earn substantial net investment income. The decision to admit workers from the new EU member states has boosted the flow of immigrants and helped to fill skills gaps. While openness may increase exposure to downside global risks, it also contributes to the flexibility that allows the economy to respond to adverse developments quickly. However, this flexibility alone would not be sufficient to smooth developments in the face of some major international shocks.
10. Fiscal policy needs to have sufficient cushions to permit a response to shocks. During the global downturn of 2000-03, a large fiscal expansion played an important role in moderating the slowdown in the United Kingdom. At present, the capacity for similar action is narrowing. First, we expect net debt to rise to around 39 percent of GDP before it stabilizes, leaving little room even for automatic stabilizers to operate fully in a downturn if debt is to remain below 40 percent of GDP. Second, the tax-to-GDP ratio has risen in recent years to about its level in the second half of the 1980s. Further tax increases would risk adversely affecting incentives to work and invest. Finally, favorable global financial conditions may be providing a temporary boost to the financial sector; in this case, some of the recent strength in revenue would not be permanent. Against this background, realizing the government's medium-term projection of an overall fiscal deficit below 1½ percent of GDP is essential to stabilize and then gradual reduce the ratio of net debt to GDP. This would ensure—even through difficult times—that debt remains below 40 percent of GDP, a limit that has served the economy well.
11. Monetary policy is well-positioned to respond to shocks. Given projected nominal GDP growth of about 5 percent over the medium term, the policy interest rate is now broadly neutral and has ample room for maneuver. However, globalization is providing challenges to the formulation of monetary policy in at least three respects. First, the impact of immigration is making it harder to assess the balance between demand and supply. Second, rapid growth in manufactured imports from emerging Asia has dampened inflation in recent years, but judging the duration of this effect is difficult. Third, greater mobility of labor and goods may be weakening the relationship between economic slack and inflation, possibly increasing the time it takes for inflation to return to target. Against this background, we support the Bank of England's efforts to disentangle the wider range of current influences on inflation, effectively communicate them to the public and financial markets, and, if necessary, respond aggressively to contain inflation.
12. The financial sector starts from a position of strength, and the authorities continue to promote the system's resilience. The key concerns are low-probability events with potentially severe consequences. In addition to global risks, vulnerabilities include high and rising household debt, increasing exposure to complex and potentially illiquid instruments, and growing reliance by banks on wholesale funding, which raises liquidity risk. In addressing these risks, the authorities are, appropriately, aiming to balance the costs and benefits of regulation. We support the authorities' efforts to identify and encourage best practices in stress-testing. Given the growing cross-country linkages between financial systems, the authorities' plans to further enhance international crisis prevention and management arrangements are welcome.