Public Information Notice No. 12/81

Public Information Notice: IMF Executive Board Concludes 2012 Article IV Consultation with the United Kingdom

July 19, 2012

On July 16, 2012 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United Kingdom.¹

Background

The UK’s economic recovery has been sluggish, as the needed hand-off from public to private demand-led growth has not fully materialized. Economic activity is projected to gain modest momentum going forward, but the pace of expansion is expected to be weak relative to the scale of underutilized resources. As a result, the output gap is projected to remain sizeable for an extended period, keeping unemployment (currently over 8 percent) elevated and raising the risk that sustained cyclical weakness reduces the economy’s productive capacity. Inflation has been on a downward trend since peaking in September 2011 and is expected to decline below the 2 percent target over the medium term, as the large output gap exerts disinflationary pressure. Risks to this central scenario are large and predominantly to the downside, including from further setbacks to the euro area crisis and larger-than-expected headwinds from public and private sector deleveraging.

Current polices aim to assist economic rebalancing and financial sector healing. Substantial progress has been made toward achieving a more sustainable budgetary position and reducing fiscal risks, with structural fiscal adjustment of about 4¾ percent of GDP over the last two years. The pace of consolidation is expected to ease to ½ percent of GDP in FY2012/13, reflecting the authorities’ decision not to undertake additional discretionary tightening in the short term in response to substantial downward revisions to potential GDP. Under current fiscal plans, the pace of consolidation is expected to accelerate next year to around 1½ percent of GDP.

Bold monetary stimulus has been provided to help counteract the weak economy and rising risks of undershooting the inflation target. Specifically, the Bank of England resumed its purchases of government bonds (quantitative easing) in late 2011, with additional purchases announced in February and July 2012. Despite this monetary easing, credit conditions remain tight due to elevated risk aversion, an incomplete process of financial repair, and rising bank funding costs associated with intensified stress in the euro area. More recently, the authorities announced credit easing measures to more directly lower private-sector borrowing costs, including through broader provision of bank funding and liquidity.

The financial regulatory structure is also being revamped. A Financial Services Bill to provide a permanent legal basis for the new regulatory framework is expected to come into force in early 2013, and a White Paper on Banking Reform has been published with proposals for additional loss absorbency capacity and ringfencing of retail operations.

Executive Board Assessment

Executive Directors welcomed the authorities’ efforts aimed at economic rebalancing, including bold monetary stimulus, financial sector policies to build buffers and strengthen oversight, and major progress toward a more sustainable fiscal position. However, they cautioned that a stalling recovery, high unemployment, and uncertain external conditions continue to present significant challenges.

Directors welcomed recent announcements to implement additional monetary stimulus via further quantitative easing, and most Directors believed that further easing may be needed, including consideration of a cut in the policy rate. However, a number of Directors cautioned that scope to provide more stimulus through rate cuts and standard quantitative easing may be limited, given that interest rates on government debt are already very low. Noting that elevated bank funding costs have limited lending to the private sector, Directors welcomed recent measures aimed at lowering private-sector borrowing costs through broader provision of bank funding against collateral. They considered that, depending on the use and performance of these new programs, further credit easing measures may be needed. Directors underscored that such measures should be complemented with regulatory policies to ensure that banks do not become dependent on such facilities.

Directors considered that deeper budget-neutral reallocations could also support recovery, including greater investment spending funded by property tax reform or spending cuts on items with low multipliers. They emphasized that automatic stabilizers should continue to operate freely, and underscored the need for shielding the poorest from the impact of consolidation.

Looking ahead, Directors commended the authorities for their strong commitment to achieve fiscal sustainability over the medium term. Many Directors supported the authorities’ prudent approach toward further fiscal easing, emphasizing the importance of not undermining fiscal sustainability and hard-won credibility, and noting the potential negative feedback loops between public finances and the financial sector. Many Directors also noted the difficulty of setting a specific timetable for potential future fiscal policy actions in the current uncertain environment. However, a number of other Directors considered that fiscal consolidation should not be accelerated as planned if growth does not build momentum even after further monetary and credit easing measures, noting that persistent weak growth that hinders achievement of fiscal targets might also pose risks to credibility. These Directors noted that any adjustment to the path of consolidation should be in the context of a multi-year plan and ideally accompanied by deeper long-run entitlement reform to help preserve credibility.

Directors stressed the importance of continuing with efforts to bolster financial stability to anchor a strong and durable recovery, reduce the risk to taxpayers, and limit spillovers from shocks that are transmitted through the UK’s financial system. They emphasized that policies should focus on strengthening bank balance sheets by building capital rather than reducing assets to balance stability and growth considerations. Directors also welcomed the review of banks’ liquidity guidelines to account for the availability of Bank of England liquidity insurance.

Directors emphasized the need to address expeditiously the issue of “too big to fail.” They welcomed the progress in developing a more flexible resolution framework, “living wills” for major institutions, and reform proposals by the Independent Commission on Banking. Directors also agreed that a broader macroprudential toolkit for the Financial Policy Committee is desirable, including powers to limit loan-to-value and loan-to-income ratios.

Directors supported efforts to intensify supervision and stressed that provision of adequate resources will be key to achieving this objective. They also considered that greater authority over financial holding companies than currently envisaged in the draft Financial Services Bill will be essential for the future Prudential Regulatory Authority. They emphasized that international collaboration on key regulatory and supervisory issues will further support financial stability, and they encouraged the authorities to continue their vital and constructive role in this regard.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.