United Kingdom—2011 Article IV Consultation Concluding Statement of the Mission

June 6, 2011

Aided by the implementation of a wide-ranging policy program, the post-crisis repair of the UK economy is underway. However, the weakness in economic growth and rise in inflation over the last several months was unexpected. This raises the question whether it is time to adjust macroeconomic policies. The answer is no as the deviations are largely temporary. Strong fiscal consolidation is underway and remains essential to achieve a more sustainable budgetary position, thus reducing fiscal risks. The inflation overshoot is driven largely by transitory factors, and hence maintaining the current scale of monetary stimulus is appropriate given fiscal adjustment and subdued wage growth. This macroeconomic policy mix will also assist in rebalancing the economy toward investment and external demand. Bank balance sheet repair continues, but vulnerabilities remain and strong domestic measures and international coordination are needed to further bolster financial stability. Indeed, the stability and efficiency of the UK financial system is a global public good due to potential spillovers and thus requires the highest quality of supervision and regulation. Nonetheless, there are significant risks to inflation, growth, and unemployment. If they materialize, the policy response will depend on the nature of the shock.

The central scenario

1. The economy is expected to grow at a moderate pace in 2011. Growth was flat over the last two quarters, as the inventory cycle—which helped power growth through much of 2010—came to a close and with consumer confidence impaired by spiking commodity prices, a soft housing market, and headwinds from necessary fiscal consolidation. Going forward, the latter two factors and the ongoing process of household and bank balance sheet repair will continue to weigh on growth. However, recovery should be buoyed by private investment, as it rebounds from unsustainably low levels and is supported by low interest rates and corporates’ strong cash positions. In addition, net trade is improving along with global recovery and may benefit further if labor productivity—which has been depressed in part due to relatively high labor hoarding in the UK—rebounds and improves competitiveness. Led by these forces, expansion is expected to resume in 2011, though real GDP growth will remain a moderate 1½ percent before accelerating gradually to around 2½ percent over the medium term.

2. Inflation is likely to remain above 4 percent for most of 2011, but then gradually return near the 2 percent target as transitory factors dissipate. Spiking commodity prices and large indirect tax hikes have temporarily boosted headline inflation. However, core inflation excluding tax effects remains around 2 percent. With commodity futures indicating that oil and food prices will stabilize, inflation is expected to return near the target around the end of 2012 as the effects of recent shocks dissipate and as spare capacity keeps underlying inflation in check. Leading inflation indicators support this outlook: growth rates of credit, broad money, and wages are all low, and inflation expectations remain contained.

Macroeconomic policies in the central scenario

3. The current settings of fiscal and monetary policy remain appropriate in the central scenario. The fiscal consolidation plan aims to stabilize government debt by FY14/15, thereby preserving confidence in debt sustainability. Although consolidation will create headwinds for short-term growth, it will also assist disinflation and can thus be countered by looser monetary policy than otherwise. In this context, the current accommodative monetary stance is appropriate, given the projection that inflation will return to target in a reasonable timeframe and the uncertainty regarding the strength of the recovery.

4. Such a policy mix will support economic rebalancing to a more sustainable equilibrium. Tight fiscal and accommodative monetary policy will help keep real interest rates low and sterling competitive. This economic environment will assist public and private balance sheet repair while promoting expansion of investment and net exports. This is necessary if robust output and employment growth are to be achieved at the same time that private and public consumption are eased to more sustainable levels.

5. If growth resumes as expected in the coming quarters, the case for monetary tightening would increase. In this central scenario, the pace of monetary tightening should be gradual, given the extended period of fiscal contraction and the high sensitivity of house prices (and hence consumption and residential investment) to short-term interest rates. Furthermore, the real interest rate consistent with stable inflation and full employment may remain low for some time, as it is likely that the financial crisis has shifted down the demand for investment and consumption at any given interest rate. This view is supported by the low expected path for short-term rates over the next 2-3 years, as embedded in government bond yields. However, monetary tightening would need to be earlier and faster if leading inflation indicators—especially unit labor costs and inflation expectations—turn more worrisome.

6. On the fiscal side, the government has already made significant progress in implementing its consolidation plan, though challenges remain. Structural fiscal adjustment in FY10/11 is estimated at roughly 2½ percent of GDP, largely reflecting higher taxes and the reversal of fiscal stimulus. Though the pace of adjustment will ease somewhat going forward, it will also become increasingly reliant on expenditure cuts, as specified in the Spending Review. Evidence suggests that spending-led consolidations lead to longer-lasting budgetary improvements, but there may also be implementation challenges, requiring careful management to ensure delivery of the targeted consolidation while shielding the poor.

7. Building on progress already made, further structural reforms will help address remaining longer-term fiscal imbalances and support medium-term growth. Of note,

• further accelerating increases in the state pension age and indexing it to longevity would help reduce longer-term imbalances due to ageing and could increase labor supply by encouraging longer working lives;

• reform of public-service pensions, as proposed by the Hutton Review, could help improve their structure and better align average public-service compensation with private-sector equivalents; and

• efforts to ease tight planning restrictions—a focus of The Plan for Growth—could help spur more construction and productivity-enhancing development.

8. Institutional reforms adopted by the government should assist these objectives. In particular, the recently passed legislation to put the independent Office for Budget Responsibility (OBR) on a permanent footing is welcome, as this new institution will help strengthen the credibility of fiscal analysis and forecasts. Publication of the OBR’s first fiscal sustainability report in July 2011 should enhance analysis and public debate of longer-run fiscal challenges. 

Risks and policies responses

9. Risks and uncertainty around this central scenario are significant. Large risks to growth and inflation arise from uncertainties surrounding euro-area sovereign turmoil, the housing market, the size of the output gap, and commodity prices. Indeed, unexpected spikes in commodity prices were a significant factor behind revisions to our 2011 inflation and growth forecasts since the 2010 Article IV consultation. Another risk is uncertainty surrounding the size of fiscal multipliers and the degree to which private demand and net exports will be vibrant enough to pick up the slack from fiscal consolidation. Uncertainties arising from key risks are further compounded by the unusually large disconnect between recent weak GDP outturns and other indicators that are stronger (e.g., rising employment, higher-than-forecast tax revenue, and stronger private sector surveys), making it all the more difficult to ascertain the economy’s near-term direction.

10. Policies will need to react if major risks materialize. Various scenarios can be painted, both on the upside and downside. The appropriate policy response, and its speed, will depend crucially on the nature of the shock, keeping in mind the Government’s determination to follow through with planned spending reductions in order to maintain fiscal credibility. For example:

• If growth and inflationary pressures are stronger than expected, monetary tightening will need to accelerate, and all fiscal windfalls should be saved to contribute to deficit reduction and disinflation.

• Conversely, if the economy experiences a prolonged period of weak growth and high unemployment—and if inflationary pressures consequently ease—fiscal automatic stabilizers should operate freely (as the fiscal mandate is designed to allow) and the current monetary policy rate should be maintained for an extended period. In such a risk scenario, it will important to ensure that the slowdown does not become entrenched due to capital scrapping and cyclical unemployment becoming structural. This is not the central scenario, but if this appears to be in prospect, then some combination of the following would need to be considered: (i) expanded asset purchases by the Bank of England and (ii) temporary tax cuts. Such tax cuts are faster to implement and more credibly temporary than expenditure shifts and should be targeted to investment, low-income households, or job creation to increase their multipliers. Simultaneous adoption of deeper long-run entitlement reform would be desirable to safeguard fiscal sustainability and market confidence.

• In the event of both persistent weak growth and high inflation, the appropriate response depends on the source of this condition: if it is due to further commodity price volatility, policies need not respond unless there is clear evidence of second-round effects (e.g., higher import prices feeding into higher wage growth). In the more difficult case in which weak growth and high inflation result from a much narrower-than-estimated output gap (which would be indicated by rapid wage growth), policies will have little choice but to tighten to re-anchor inflationary expectations. A narrower output gap would also imply a higher-than-currently-estimated structural deficit and therefore would require further fiscal tightening over the medium term.

Improving financial system soundness

11. UK financial system stability is important for domestic and global macroeconomic stability and requires the highest quality supervision and regulation. Prospects for orderly rebalancing toward private sector-led growth will depend in part on continued financial sector healing. Furthermore, an analysis of spillovers from the UK shows that the size and role of the UK financial system in global intermediation puts it in a position to originate and transmit shocks to the global financial system, but also to dampen them. Financial stability in the UK is thus a global public good.

12. It is therefore encouraging that banks have strengthened their capital and liquidity positions over the last year. All major banks are ahead of schedule in their transition to Basel III rules. They have also reduced their reliance on wholesale and official funding.

13. However, the recovery process is not yet complete, as highlighted by analysis carried out under the IMF’s Financial Sector Assessment Program (FSAP). The two large banks with government stakes have made good progress in the implementation of their restructuring programs, and it will be important that these efforts are sustained. Stress tests for major banks reveal adequate levels of capitalization under severe macroeconomic scenarios—with the caveat that lender forbearance may, in some cases, have masked the extent of risks, given the high indebtedness of the household and commercial real estate sectors. Potential losses from exposures to vulnerable European countries are not a threat as long as shocks do not lead to stresses in core European banks to which UK banks have large exposures. Major UK banks have adequate liquidity buffers under most scenarios but—like other global banks—remain vulnerable to sustained disruptions in funding markets. The new discount window facility and prepositioning of collateral aimed at facilitating quick use of the facility are important in managing such extreme stress events.

14. Requiring financial institutions to build up capital and liquidity buffers is thus proper and necessary. The Financial Services Authority (FSA) has imposed stringent capital and liquidity regulations that require resilience under stressed conditions, and approval of dividends and variable remuneration is linked to the outcome of stress tests. These safeguards are appropriate given the specific vulnerabilities of the UK financial system and should be accompanied by home-host coordination to address liquidity needs in times of stress. 

15. Regulatory requirements need to be complemented with high-quality supervision. Further improvement in the FSA’s assessment of the robustness of banks’ processes such as loan classification, impairment determination, and valuation practices are needed, and plans to enhance these aspects of supervision are welcome. It is also important that the regulatory authority be provided with enforcement powers at the holding company level.

Strengthening the oversight framework

16. The transition to a new institutional framework for regulation and supervision requires careful management. The reform proposals to clarify the mandates of the new prudential regulator, new financial conduct authority, and new macroprudential authority are welcome. The transition to this “triple peak” model should not divert resources and attention from efforts to enhance supervision of the financial sector, which is still in recovery mode.

17. The establishment of the Financial Policy Committee (FPC) is an important step in developing mechanisms to mitigate systemic risk. For the FPC to be credible, it will be important to set realistic expectations of what macroprudential regulation can achieve, especially in its early stages of implementation. A range of macroprudential tools should be considered given uncertainties regarding their effects and the nature of future risks. The FPC will also have a unique perspective to contribute to surveillance of global financial stability.

18. The plan to introduce a proactive intervention framework that increases in intensity on the basis of the seriousness of the problem is welcome. It is important that the framework legislation include explicit support for early intervention by the supervisor in dealing with prudential problems.

19. The UK lags behind many other countries in standards for the public disclosure of bank and insurance sector data. Regular and comparable data on an institution basis should be published, including non-confidential data from prudential returns. The work underway to achieve this is welcome.

Dealing with the “Too-Important-To-Fail” Problem and International Dimensions

20. Progress has been made in addressing the too-important-to-fail problem, but more needs to be done. Regulatory ratios have been strengthened, and a bank levy on wholesale funding has been introduced. Further tax reforms to reduce incentives for excessive leverage, such as a revenue-neutral allowance for corporate equity, could also be considered. Ring-fencing of retail operations and establishment of depositor preference, as proposed by the Independent Commission on Banking, will improve resolvability of the retail entity. However, ring-fencing must be weighed against the costs of such an approach and does not necessarily improve resolvability of the whole entity unless complemented by measures that improve loss absorption capacity (capital and liquidity surcharges, contingent capital, debt subject to bail-in), recovery and resolution plans, and cross-border resolution arrangements. International collaboration will be critical for progress in these areas, and the UK authorities should continue exercising leadership on these matters.

21. Central counterparty clearing houses (CCPs) should be subject to robust standards to avoid becoming too-important-to-fail. CCPs will enhance transparency in bilateral clearing. However, they will bear counterparty risk, and it is therefore vital that they maintain robust prudential and risk management standards and that contingency plans are put in place to deal with their failure.

22. The stability of the UK financial sector critically depends on a stronger international framework for oversight of cross-border banks. There are serious limitations to what the UK can do alone, particularly with respect to institutions that it hosts, such as branches of foreign bank entities. Gaps in this domain must be addressed through international cooperation. 

23. The UK authorities should continue to work toward an ambitious international package of regulatory reform and rigorous implementation of this package in the EU as agreed by the G20. We strongly support the authorities’ efforts to advocate for European legislation under the EU Capital Requirements Directive (CRD4) that enable the establishment of strong standards that (i) exceed Basel III minima, including by setting ambitiously high capital requirements together with significantly topped-up capital demands on systemically important financial institutions, and (ii) allows flexibility for national authorities to introduce macroprudential tools, including adjusting capital and liquidity requirements or varying risk weights, to address emerging financial and systemic risks. Collaboration with other macroprudential bodies will be important to ensure home-host coordination and reciprocity where appropriate.