Public Information Notice No. 04/15

Public Information Notice: IMF Concludes 2003 Article IV Consultation with the United Kingdom

March 5, 2004

On March 3, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United Kingdom.¹

Background

The UK has weathered the global slowdown well. After faltering in the wake of the Iraq war, economic activity has staged a strong recovery. Real GDP grew by 2.3 percent in 2003, with quarterly growth rates rising above trend in the second half. The upswing reflects not only strengthening external conditions but also the continued buoyancy of domestic demand driven by expansionary monetary and fiscal policies, robust increases in house prices and rising household debt. The labor market has been resilient through the downturn, with unemployment at a 30-year low. Inflation, measured by the RPIX remained near its target of 2.5 percent, while CPI inflation has been for some time some 0.6 percentage point below the new target of 2 percent set in December 2003.

In the first increase in three years, the Monetary Policy Committee (MPC) of the Bank of England hiked rates by 25 basis points in November 2003. It then followed through with an additional 25 basis point increase in February this year, taking the policy rate to 4 percent. In doing so, the MPC noted the world economic recovery had become more broadly based, growth in the second half of last year had been above trend and surveys pointed to a pickup in the pace going forward. Further, household spending and borrowing remained resilient and the housing market strong. Continued growth above trend meant inflationary pressures were likely to pick up gradually over the next two years. While CPI inflation is currently below the 2 percent target rate, an increase in rates was necessary to keep it on track to meet the new target in the medium term.

The budget position has swung since 2000/01, from a surplus of 1½ percent to a projected deficit of 3½ percent of GDP in 2003/04. The weakening reflects not only cyclical factors but also planned increases in spending to improve public services and unexpected revenue shortfalls attributable in particular to declines from the financial sector since the global equity market bubble burst. The fiscal expansion has been consistent with the UK fiscal framework, based on a golden rule and a sustainable investment rule, because of wide margins accumulated in the late 1990s. With the cyclical upturn, the recovery in financial market activity, improvements in tax collection and rising effective tax rates from the fiscal drag, the deficit is expected to decline, though views differ on the extent to which this will happen in the absence of policy actions.

The Treasury's June 2003 assessment of the five tests for EMU entry concluded that the case for entry was not yet "clear and unambiguous". In reaching this conclusion, the Treasury highlighted the differences in structure of the housing and household debt markets between the UK and the euro area, though there had been significant progress in meeting the conditions for entry since the initial 1997 assessment. To facilitate convergence with the euro area, the government has taken several initiatives, including the adoption of an inflation target formulated in terms of the EU harmonized inflation index and reviews to identify reforms on both the demand and supply sides of the housing market.

Executive Board Assessment

Directors commended the continued strong performance of the United Kingdom's economy. Growth remained resilient in the face of the global slowdown and has picked up well ahead of most other industrial countries, while inflation remained close to target and unemployment is at record lows. Directors attributed this robust performance to countercyclical monetary and expansionary fiscal policies within well established and transparent policy frameworks, and to structural factors such as high flexibility of labor, product, and financial markets following decades of reform. Directors, however, noted that the buoyancy of domestic consumption has also been fuelled by robust increases in house prices and household debt, which has increased uncertainty on future developments.

Looking ahead, with external conditions improving and domestic demand maintaining its momentum, Directors expected growth to remain strong. The main risk to this outlook stemmed from the possibility of an abrupt adjustment in house prices and a consolidation of household balance sheets, with possibly protracted effects on consumption. Although the monetary and fiscal frameworks lowered this risk, Directors stressed that the possibility of a hard landing in house prices and consumption cannot be ruled out, particularly given uncertainties about the distribution of household assets and liabilities. To minimize these risks, prudent macroeconomic policies are needed.

Directors agreed that monetary policy should continue to tighten to facilitate a soft landing scenario. They stressed that there is a strong case for raising rates preemptively given limited slack in the economy, the strength of the ongoing recovery, as well as the ebullience of the housing and household debt markets. They noted that the increased sensitivity of households' debt servicing burden, and the higher uncertainty on the response of consumption to interest rate hikes called for an "early but gradual" strategy of rate increases. In this context, they viewed the November and February rate hikes of 25 basis points as appropriate. Some Directors noted that the implications for monetary policy of rising asset prices were not clear-cut. Directors generally agreed that the recent shift in the inflation target from RPIX to CPI seems unlikely to have major implications for the conduct of monetary policy, and were re-assured that the reason for the change in the inflation target has been well communicated to the public.

Noting the widening of the fiscal deficit (including in structural terms) over the last three years, Directors concurred that the fiscal deficit needs to decline in the period ahead in order to observe the fiscal rules, strengthen fiscal fundamentals, and support monetary policy during the cyclical upswing. However, many Directors recommended a somewhat larger decline in the fiscal deficit in the medium term than that projected in the November pre-budget report. In the view of these Directors, a larger decline in the deficit is important to provide more room for counter-cyclical fiscal policy and private investment in the future, and to achieve a fiscal balance more consistent with long-term fiscal requirements. To achieve the recommended fiscal adjustment, these Directors recommended that new fiscal measures be adopted. They considered that reliance on cyclical effects and a rebound in revenues from the financial sector may not be sufficient to achieve the desired decline in the deficit. A number of Directors, however, considered the pace of fiscal adjustment projected in the pre-budget report to be appropriate, particularly in view of the low inflation rate and public debt. In any event, Directors urged the authorities to follow developments closely, especially revenue collections, and to take any necessary corrective actions promptly.

Directors in general called for moderating the growth of spending in areas where current plans involve sharp increases. This would limit the risk of inefficiencies and help fiscal consolidation. In this regard, Directors welcomed the continued strengthening of the expenditure management framework, including the special transparency and accountability requirement for public/private partnerships and private finance initiatives to safeguard the comprehensiveness of the budget process and avoid contingent liabilities. However, they recommended that the authorities take further measures to ensure that increased spending is delivering value for money. Moderating the growth rate of spending would allow time to evaluate whether the new framework is working, and to improve it if needed. Some Directors welcomed recent measures to broaden the application of user fees in public services, and they suggested that both efficiency and fiscal adjustment would benefit from further measures in this regard, including in the health care sector.

Directors agreed that current and future public pension obligations are modest compared with most other European economies. They viewed the authorities' strategy on pensions, centered on increasing the share of pensioners' income from private sources, as appropriate. However, Directors observed that the success of this approach is contingent on private saving increasing enough, and that there are some indications that this has not been the case so far. In this context, Directors saw risks that public pension liabilities could be higher than currently projected. Therefore, Directors welcomed the establishment of an independent Pension Commission, entrusted with assessing the need for further reform, including the potential for introducing compulsory elements to the pension system.

Directors endorsed the authorities' agenda for raising productivity in the United Kingdom, observing that productivity continues to lag behind that in other industrialized countries. Although they viewed the authorities' multi-pronged approach as appropriate, Directors saw a particular need for systematic monitoring and evaluation of ongoing programs in order to allow for retirement of unsuccessful initiatives, the extension of successful ones, and a targeted prioritization over time. A few Directors also emphasized the importance of human capital development.

Directors welcomed the publication of the Treasury's assessment of the five tests for EMU entry, noting its contribution to informing the public debate on this important decision. They also welcomed the initiatives launched by the authorities to follow up on the assessment, especially the reviews of the demand and supply sides of the housing market. Some Directors noted that the change in the inflation target moves the UK monetary framework closer to the EMU framework. Directors considered that the next assessment could be enriched by elaborating on some difficult issues, such as the long-term implications of joining EMU before full convergence is achieved and the potential costs of delaying entry. However, some Directors pointed out that it would be difficult to take a decision on EMU entry based on technical considerations alone.

Directors concurred with the assessment that the United Kingdom's system of financial supervision is sound. They observed that, as reported in the 2002 FSAP, UK banks appear to be sufficiently profitable and well-capitalized to absorb possible macroeconomic shocks without systemic distress. Nevertheless, Directors urged the authorities to be vigilant about the adverse effects of a possible decline in mortgage collateral values. Directors welcomed the ongoing reform of insurance supervision and regulation and noted that, after several years of considerable stress, conditions in the sector had stabilized. They also welcomed the authorities' ongoing efforts in the area of combating money laundering and terrorism financing.

Directors commended the United Kingdom's commitment to promoting trade liberalization, including reforming the Common Agricultural Policy. They encouraged the authorities to continue to use their position in international institutions to reintroduce momentum in the Doha round negotiations, and to increase the effective access of the least developed countries to industrial country markets. Directors welcomed the ongoing increase in official development assistance and encouraged further efforts to achieve the UN target of 0.7 percent of GNP.

It is expected that the next Article IV consultation with the United Kingdom will be held on the standard 12-month cycle.