IMF Executive Board Concludes 2009 Article
IV Consultation with the United KingdomPublic Information Notice (PIN) No. 09/84
July 16, 2009
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2009 Article IV Consultation with the United Kingdom is also available.
On July 10, 2009 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United Kingdom.1
The United Kingdom has been hit hard by the global financial crisis. The economy was particularly vulnerable to the crisis because of the large size of its financial sector, high household indebtedness, and strong cross-border links. Economic growth has turned sharply negative since mid-2008, house prices have fallen by more than 20 percent from their peak, the unemployment rate has increased and inflation has come down. Driven by increased risk perceptions, sterling has depreciated significantly between mid-2007 and early 2009, helping to narrow the UK’s external imbalances, before regaining some strength in recent months. With banks focused on reducing leverage, the growth of credit to the private sector has fallen to nearly zero, and is expected to remain low in the near term.
In response to the crisis, the authorities have taken wide-ranging measures to stabilize the financial system and support demand. The measures included expansion of the Bank of England’s liquidity facilities, significant public capital injections in several large banks, an Asset Protection Scheme to limit losses on troubled bank assets, and guarantees for banks’ debt. Considerable policy stimulus has also been introduced to support the economy. The Bank of England reduced interest rates to a historic low of 0.5 percent by March 2009 and began purchasing assets, financed by an expansion of base money (quantitative easing). Meanwhile, the government has put in place a discretionary fiscal stimulus package of around 2 percent of GDP. These policies have helped avert a systemic breakdown in the financial system, although vulnerabilities remain.
The crisis and the ensuing recession have led to a rapid deterioration of public finances. With revenues highly sensitive to the economic cycle, financial sector activity, and asset prices, fiscal deficits have widened sharply and are expected to be about 13 percent of GDP in 2009 and 2010. Gross general government debt is set to double over the next five years to nearly 100 percent of GDP. At the same time, contingent liabilities of the government have increased rapidly.
The economic outlook is highly uncertain. Recent indicators suggest that economic activity has begun to stabilize. However, the recovery is likely to be slow and subdued as banks and households go through a difficult balance sheet adjustment. GDP is expected to contract by 4.2 percent in 2009, with growth picking up gradually in 2010. As spare capacity continues to increase, inflation is expected to fall below the 2-percent target in the second half of 2009 and remain low for an extended period of time.
Executive Board Assessment
The Executive Directors noted that the UK economy has been hit hard by the global financial crisis and welcomed the UK authorities’ aggressive policy response. The measures taken to stabilize the financial system have been successful in averting a systemic breakdown. The significant fiscal and monetary stimulus underway will help support activity in the near-term. There are tentative signs that economic activity is stabilizing. However, Directors pointed out that the outlook for the UK economy is highly uncertain and will depend on, among other factors, the pace and extent of deleveraging of financial institutions’ and households’ balance sheets.
Directors considered that, looking forward, the projected sharp increase in public debt, the accumulation of sizable contingent liabilities, and continued financial sector fragility represent significant vulnerabilities. They therefore emphasized the importance of following credible and consistent policies to maintain domestic and external stability, limit downside risks, and strengthen market confidence. Resolving the problems in the financial sector and setting monetary and fiscal policies consistent with a firm commitment to price stability and fiscal sustainability are the main policy priorities.
Directors stressed that the most important policy task remains repairing the financial system. Significant uncertainties remain about the adverse impact of the recession on asset quality. Substantial further write-downs would result in an erosion of capital buffers and might lead to renewed doubts about the capital adequacy of individual financial institutions. These lingering uncertainties are restraining lending growth. Directors suggested that the authorities should encourage banks to strengthen their capital base and explore options to improve capital structures. The authorities should also continue their contingency planning, and a number of Directors agreed that they should be prepared to provide further public capital, if needed.
Directors welcomed the adoption of the Special Resolution Regime for financial institutions and noted that its effective implementation would require timely and comprehensive information sharing and cooperation among the tripartite authorities. The UK authorities should continue to work with international partners, including the EU, on strengthening cross-border financial stability arrangements and resolution frameworks, for example through the development of effective arrangements for crisis management and orderly exit of cross-border banks.
Directors supported a number of the proposals for enhancing the UK’s prudential framework presented in the Turner Review and in the white paper on reforming financial markets published by the Treasury. In particular, Directors endorsed the proposed enhancement of liquidity regulation, the increased emphasis on identifying system-wide risks, and proposals for a Council for Financial Stability. They encouraged the authorities to continue working with international partners on the development of new macro-prudential instruments that could help mitigate the amplitude of credit cycles. Many Directors considered that a phased introduction of a maximum gross leverage ratio could act as a useful backstop against excessive balance sheet growth. Finally, Directors recommended improving the frequency and quality of disclosure of financial information by banks.
Executive Directors considered the Bank of England’s strategy of aggressive monetary easing, aimed at maintaining inflation close to target, to be appropriate, while noting it is too early to judge the overall effectiveness of quantitative easing. Directors noted that diversifying the Bank of England’s private asset purchases further could help improve the functioning of capital markets. They welcomed the robust institutional arrangement underpinning the Bank of England’s unconventional operations, including comprehensive indemnity assurances from the Treasury. These arrangements preserve the Bank of England’s operational independence and will help assure a smooth exit from quantitative easing when warranted by economic conditions.
Directors emphasized that the success of the current policy package depends on continued trust in the sustainability of the fiscal position. A strong commitment to reverse the sharp deterioration of the public finances once the economic recovery has been established, within the context of a coherent and ambitious fiscal framework, will be essential. The focus of fiscal consolidation plans should be on putting public debt on a firmly downward path within a reasonable timeframe. Credibility would be enhanced by specifying concrete expenditure and revenue measures to achieve the desired adjustment. Long-term sustainability would also be helped by implementing structural reforms to limit the rise in ageing-related costs.