Financial district of London, United Kingdom: key policy priority remains restoring health of financial institutions (photo: Toby Melville/Reuters)
ECONOMIC HEALTH CHECK
The United Kingdom has been hit hard by the global financial crisis. Economic activity has weakened sharply, the unemployment rate has increased, property prices have plunged, and inflation has fallen despite a significant depreciation of sterling. In its staff report on the annual Article IV consultation with the United Kingdom, the IMF projects a contraction of 4.2 percent in 2009, with a modest recovery starting in 2010.
“Once the recovery is established, the authorities will need to move more aggressively in their fiscal consolidation plans and, to be specific, it will be important to set public debt on a sharper downward path than is envisaged in the 2009 budget,” Ajai Chopra, IMF mission chief for the United Kingdom, said.
Emergency response
The U.K. economy was especially vulnerable to the global financial shock because of its large and highly leveraged financial sector, overheated property markets, high household debt levels, and strong cross-border links. The authorities acted decisively to contain the crisis.
Banking sector liquidity has been shored up, public capital has been injected into weak banks, and troubled assets have been insured against further large losses. At the same time, economic activity is being supported by unprecedented monetary policy easing and sizable discretionary fiscal stimulus.
These aggressive policy measures have helped avert a systemic breakdown in the financial sector. Simultaneously, the flexible exchange rate has acted as a shock absorber, depreciating early in the crisis and shifting demand toward domestic production. There are now tentative signs that economic activity is stabilizing and confidence returning.
Vulnerabilities remain
However, the speed and the strength of recovery remain highly uncertain and will depend, among other factors, on the pace and extent of adjustment in bank and household balance sheets. Despite recent signs of stabilization, the economy’s resilience to potential future shocks also is not yet fully assured.
The surge in public sector borrowing, combined with the rapid accumulation of contingent liabilities and continued financial sector fragility, represent significant vulnerabilities. Therefore it is critical to implement credible and consistent policies to maintain domestic and external stability, limit downside risks, and strengthen market confidence.
From rescue to repair
The key policy priority remains restoring the health of financial institutions. The risk of a systemic crisis has clearly diminished. However, the financial system may not yet be in a position to increase lending sufficiently to underpin strong recovery. U.K. banks reported record writedowns and losses in 2008, and substantial further writedowns are expected this year and next, as the recession takes its toll on credit quality.
Rising unemployment, further drops in property prices, and corporate sector weakness are bound to reduce banks’ capital buffers and might even lead to renewed doubts about capital adequacy in individual institutions. These lingering uncertainties are restraining new lending.
Only sufficiently large capital buffers would enable banks to resume normal credit activity. Banks should take advantage of improving market conditions to augment their capital base. In the meantime, the authorities should stand ready to provide further public support, if needed. Banks should also explore options to preserve capital cushions and improve capital structures, for example by restraining dividend payouts or converting preference shares to common shares.
Beyond the short-term firefighting, the crisis has highlighted the critical need to strengthen the United Kingdom’s prudential framework. The adoption a new Banking Act, creating a special resolution regime for failing banks, is a welcome improvement, as is the move from a “light-touch” to a more hands-on supervisory regime. Complementing these steps with more frequent and comprehensive disclosure of financial information by banks would help reduce uncertainty and strengthen market discipline.
More generally, the recent Turner Review and the Treasury’s white paper on reforming financial markets have presented a number of important proposals for improving the regulatory and supervisory system. Progress on refining and implementing these proposals is critical, especially in the areas of capital adequacy, liquidity management, and macro-prudential tools to mitigate the amplitude of credit cycles. The U.K. authorities should also continue to work with international partners, including the European Union, on strengthening cross-border financial stability arrangements.
Unconventional monetary tools
With inflation now below the 2-percent target and expected to remain there for an extended period of time, the Bank of England’s (BoE) aggressive monetary policy easing has been timely and appropriate. Having cut the policy rate to its lower bound, the BoE has adopted a policy of quantitative easing—buying public and private debt securities financed by creation of base money.
It is too early to judge the effectiveness of this policy, but initial results appear to be moderately encouraging—government bond rates have remained low and liquidity in targeted private credit markets has improved. There may be scope for further diversification of private sector asset purchases. This would help improve the functioning of viable capital markets and sustain the flow of credit to the real economy.
However, unconventional policies also come with new uncertainties and risks. A particular concern is the risk to central banks’ balance sheets, and implicitly to their operational independence. It is reassuring in this regard that the BoE operates within a very robust institutional arrangement. All current asset purchases are based on an explicit Treasury authorization and covered by a comprehensive ex ante indemnity for possible losses.
At the same time, the BoE also will not need approval to time and implement an exit from quantitative easing. These arrangements allow monetary policy to fully retain its focus on price stability. Of course, at a more fundamental level, confidence in the independence of monetary policy hinges on the stability of public finances.
Restoring fiscal sustainability
The success of the current policy package depends on the continued trust of the public in the solvency of the government. Should fiscal sustainability come into question, interest rates would rise despite monetary easing efforts, the ability of the government to provide support to the financial sector would be severely limited, and pressures on the currency could emerge.
To limit such risks and increase resilience to shocks, there needs to be a credible commitment to reverse the deterioration of the fiscal position in the medium term. Based on the 2009 budget, gross general government debt would reach 100 percent of GDP by 2014/15. The focus of the adjustment should be to put public debt firmly on a downward path, ideally faster than envisaged in the current budget. Credibility would be enhanced by providing clarity on the specific revenue and expenditure measures to achieve the desired debt and deficit reduction.
Road to recovery
The United Kingdom faces many challenges on its road to recovery. However, if the authorities continue to handle the crisis successfully, ensure a return to a sustainable fiscal path, and use the current momentum to implement wide-ranging reforms in the regulation and supervision of the financial system, the foundations would be laid for a return to steady growth.
Comments on this article should be sent to imfsurvey@imf.org
