July 10, 2009
My authorities held a very open and productive consultation with the IMF staff Mission in May. They agree with the broad thrust of the staff report, and in particular welcome its support for the strength of the UK’s policy response to the global crisis. The staff report rightly identifies the exceptional uncertainties that characterise policymaking in the current environment, as well as the longer term challenges that will need to be addressed once the crisis has passed. My statement seeks to complement the staff report by setting out my authorities’ approach to these issues in more detail and noting some areas where views differ.
Outlook and recent developments
The UK economy has contracted in the period since the last Article IV in July 2008. Whilst the outlook remains subject to significant uncertainties, the forecast set out in the Treasury’s April 2009 Budget is for a -3¾ to -3¼ percent reduction in GDP in 2009, followed by a 1 to 1½ percent growth in 2010. In addition, the Treasury assumed a phased downward adjustment to the trend level of output of around 5 percent. However, as spare capacity in the economy is brought back to productive use by 2011, GDP is forecast to grow by 3½ percent.
The economic outlook is, of course, highly uncertain at the current juncture and there are risks both to the upside and downside as highlighted by the IMF staff. Nevertheless, my authorities see some potential reasons for growth to recover more quickly than staff forecast:
the effect of the unprecedented and aggressive policy stimulus is expected to increasingly take hold;
despite the recent contraction of global demand, the lower level of sterling should shift both domestic and overseas expenditure towards UK goods and services;
the UK is already at a well-advanced stage in the inventory cycle, which should act to boost, rather than detract from, growth in the coming quarters;
to the extent that the deterioration in financial conditions has acted to weigh on economic activity in the downswing, the normalisation of credit conditions as a result of the UK’s financial sector interventions should act as a bulwark to growth in the upswing;
although we agree with staff that uncertainty around employment prospects could slow recovery, we expect the UK’s flexible labour market to allow firms, households and consumers to adjust relatively rapidly.
The latest Budget inflation forecast is broadly in line with the IMF Staff forecast for 2009 and 2010. My authorities agree that strong downward pressure from increasing spare capacity and lower energy prices means that CPI inflation will continue to ease, moving well below its target of 2 percent by the end of the year. CPI inflation is likely to remain below target during 2010 when the negative output gap is forecast to trough, though downward pressure on inflation will be countered by monetary policy support further taking hold. My authorities forecast a stronger rebound in inflation than the Staff and consider the risk of deflation in the CPI measure of inflation to be small given the monetary policy stimulus in place and the upward pressure on prices from the continued pass-through of the exchange rate depreciation. As stated in the Staff report, medium-term inflation expectations remain anchored to the inflation target, further mitigating the downside risk of a deflationary scenario.
Recent economic developments across the globe are having a profound effect on the fiscal positions of many countries and debt is likely to rise significantly in all advanced economies. The UK Government’s objectives for fiscal policy in the face of these developments remain unchanged. They are: in the short term to support monetary policy and to allow the automatic stabilisers to help smooth the path of the economy; over the medium term, to ensure sound public finances and a fair impact of spending and taxation within and between generations.
Short- term stimulus
To support the economy in the short-term, the 2008 Pre-Budget Report announced a timely, targeted and temporary fiscal stimulus package worth around 1 percent of GDP in 2009–10, including a temporary reduction in the rate of VAT to 15 percent and bringing forward £3 billion of capital spending. The 2009 Budget announced further targeted support to assist recovery including measures to provide temporary support for employment and investment. This amounts to fiscal support worth 4 percent of GDP in 2009–10 from announced measures and the operation of the automatic stabilisers.
Medium- term consolidation
My authorities fully agree with Staff that in addition to providing short-term stimulus, ensuring the sustainability and credibility of the fiscal position, and setting a path towards consolidation are extremely important. They also share staff’s view that the pace of recovery will be important in shaping the consolidation. My authorities are firmly committed to delivering the needed fiscal consolidation and have taken a number of steps to do so beyond the withdrawal of temporary stimulus measures.
First, as welcomed by Staff, the Government has taken a transparent and cautious approach to the fiscal projections. The fiscal forecast assumes that the majority of the deterioration in the fiscal position is structural. It is based on the lower end of the projected GDP forecast range. It uses independently audited assumptions on oil prices and equity prices and the VAT gap. Further, reflecting the principle of transparency, the fiscal forecasts include the high end of a range for a provisional estimate of the net impact of unrealized losses on financial sector interventions, equal to 3½ percent of GDP.
Second, in light of the current uncertain outlook, the Government has set a temporary fiscal operating rule: to set policies to improve the cyclically-adjusted current budget each year, once the economy emerges from the downturn, so it reaches balance and debt is falling as a proportion of GDP once the global shocks have worked their way through the economy in full. Setting a rule focused on steady improvement in the public finances allows the Government flexibility to adjust to unanticipated developments in the economy, while constraining fiscal policy to deliver sound public finances over the medium term.
Third, plans are in place to deliver a sustained fiscal consolidation once the economy emerges from the downturn, including a combination of adjustments to tax and spending. Reflecting uncertainty around prospects for the economy and therefore the public finances, the need to support the economy through the early stages of recovery and the need to deliver sound public finances, the Government has set out steps to ensure they are on a sustainable path. The plans entail a projected improvement in the cyclically-adjusted balance of, on average, over 0.8 percent a year from 2010–11 to 2013–14. Based on cautious fiscal forecasting assumptions, public sector net borrowing is projected to more than halve over 4 years to stand at 5.5 percent of GDP in 2013–14. As a result, net debt is projected to stabilize at 79 percent of GDP, including potential losses on financial sector interventions.
Consistent with the temporary operating rule, these fiscal plans set public finances on a path to achieve cyclically-adjusted current balance by 2017–18 and debt falling as a share of GDP by 2015–16.
My authorities will continue to do whatever is necessary to ensure sustainable public finances, while continuing to invest in public services and infrastructure.
The UK’s current monetary policy framework is well-established and, following its introduction in 1997, delivered over a decade of low and stable inflation. It enshrines a symmetric inflation target that has enabled a decisive response by the Bank of England’s Monetary Policy Committee as aggregate demand weakened and the outlook for inflation was revised downwards. Following the credit market dislocation precipitated by the collapse of Lehman Brothers in September 2008, Bank Rate was reduced by 450 basis points in just six months.
In addition, the Government established the Asset Purchase Facility to enable the Bank of England to increase the availability of corporate credit and to provide a framework for the MPC to use asset purchases for monetary policy purposes in January. Since its inception, the Bank of England has announced asset purchases of £125bn. As noted by the Staff, the Bank of England’s conventional and unconventional monetary easing has been both ‘timely and appropriate’. Of course, ascertaining the effect of this policy will take time, although the sharp drop in gilt yields on announcement provide some indication of the market’s view of its likely effectiveness. In line with Staff’s recommendations, diversifications of the Bank’s asset purchases are currently under active consideration, and consultations have taken place on both a secured commercial paper (SCP) facility and a possible supply chain finance facility.
My authorities agree that the success of the QE policy hinges crucially on the Bank of England maintaining a strict focus on price stability. As Staff note, the design of the QE framework is helpful in this regard. First the March 2009 exchange of letters between the Governor of the Bank of England and the Chancellor establishing the Asset Purchase Facility make clear that the MPC retains operational independence, with its remit unchanged. Accordingly, the MPC will decide the timing and size of asset purchases and sales, together with the level of Bank Rate; with the outlook for inflation determining the rate at which the current exceptional monetary stimulus is withdrawn. Second, the operational framework of the Asset Purchase Facility Fund, as a separate legal entity with a separate balance sheet, indemnified by the Treasury, acts to underline the operational independence of the Bank. An indication of the potential inflationary risks of this stimulus is provided by the stability of the latest medium-term inflation expectations surveys (as noted by the Staff in the report). These surveys suggest that expectations continue to be well-anchored to the inflation target.
Over the past year the UK financial sector has experienced a period of significant distress. In line with their approach to monetary and fiscal policy, the UK authorities have taken wide-ranging action to stabilise the situation in the short term, whilst also focusing on action needed to strengthen the sector over the medium term, and ensuring it can make a strong contribution to delivering economic recovery.
As the crisis heightened last year, my authorities deployed various measures (as listed in Annex I of the Staff Report) to support banks, protect depositors and maintain stability. The recapitalization scheme of October last year, and the introduction of the Asset Protection Scheme (APS) in February this year have been particularly important in stabilising banks, strengthening their capital positions, and helping to foster improved confidence. The APS provides insurance for those assets where there is the greatest degree of uncertainty about their future performance, allowing it to absorb losses and strengthen banks’ capital position. The Government has also replaced its preference shares in Lloyds and RBS with new ordinary shares, which has further strengthened their capital positions.
Additionally, to help ensure credit starts to flow into the economy again, lending commitments have been agreed with both Lloyds and RBS. RBS will lend an additional £25 billion on commercial terms over the 12 months from March 2009—£9 billion of mortgage lending and £16 billion of business lending. Lloyds will lend an additional £14 billion on commercial terms over the 12 months from March 2009—£3 billion of mortgage lending and £11 billion of business lending. Similar lending commitments have been made in respect of the subsequent 12 months and will be reviewed to ensure they reflect economic circumstances at that time.
Since the Article IV Mission, the vulnerability of the building society sector’s limited access to capital has been addressed with the introduction of Profit Participation Deferred Schemes, which were used in the recapitalization of West Bromwich Building Society. Eligibility for the Government’s Recapitalisation and Credit Guarantee Schemes has also been extended to building societies and the Government will shortly consult on measures to enable building societies to offer a floating charge over their assets to the Bank of England or other institution offering financial assistance. The February 2009 Banking Act, which was under development at the time of the last Article IV and which provides a strengthened framework for the resolution of deposit taking institutions has been put into almost immediate use, in the resolution of another building society in March 2009.
Despite ongoing uncertainties, there are a number of signs that financial conditions are slowly improving, including since the conclusion of the Staff Mission in May. Notably, the latest Bank of England credit conditions survey—published last week—suggests that there has been an increase in credit availability for both households and corporates, reversing the tightening of availability that has been seen for much of the past two years. Banks also expect credit availability to improve further in the next three months for both corporates and households. It is worth noting that much of the fall in lending has come from a reduction in non-bank credit, securities market activity and lending from foreign banks. Over the past few months lending by UK-incorporated banks has continued to expand, albeit at a decelerating rate. Recent data also suggests that house prices are starting to stabilize. Bank funding conditions - as measured by the libor/OIS spread—have continued to improve and are now at their most favourable levels since the collapse of Lehmans. More generally global financial conditions have generally eased and equity prices have continued to recover, including equity prices for UK banks.
Looking ahead, my authorities agree with Staff that further reforms are needed to strengthen the financial sector, in the UK and globally. The supervision of financial institutions is one area where urgent improvement in needed. Lord Turner’s report1 on this subject provides a thorough analysis of the key areas for reform, the interactions between them, and the implications of regulatory changes. Given the global nature of financial markets and increasing cross-border nature of bank operations those recommendations need to be considered alongside those from the G20 Heads of Government summit, and the reports coming from the EU. The UK Government will also publish a paper about its long-term vision for the financial sector later this week.
The work of Basel Committee to deliver a global framework for promoting stronger bank liquidity buffers, including greater consistency in the treatment of cross-border banking groups is also strongly welcomed by my authorities.
As agreed by all G20 Leaders when they met in Washington DC last November, my authorities are committed to undertaking a further FSAP, and expect the next exercise to be undertaken in 2011.
As noted by staff, the significant fall in the (real) external value of sterling over the past twelve months has improved the UK current account considerably, mostly reflecting stronger investment income. My authorities remain fully committed to allowing the value of sterling to be determined by market forces and indeed the sterling effective exchange rate has risen by 13 percent since its trough in December 2008. Reflecting this flexible approach, the exchange rate has acted as an effective shock absorber helping smooth the adjustment as the economy contracts.
My authorities believe Article IV surveillance needs to strengthen understanding of policy spillovers and international linkages and welcomes such analysis in the report. However, like staff, we think that the hypothetical shock (illustrated in Box 1, page 22) which assesses spillovers from the UK financial system with an illustrative cut in UK banks’ foreign lending of 50 percent is a very extreme one, and one which has a very low risk of materialising. At the height of the financial crisis in the fourth quarter of 2008, consolidated foreign claims of UK banks declined by only 14 percent and foreign lending by only 7.9 percent over their levels in September 2008.
A year of significant challenge for the UK economy has been supported by wide-ranging and decisive policy action. My authorities approach the year ahead with confidence that is nevertheless tempered with caution given the challenges ahead. International collaboration on the policy response to the crisis as it evolves strengthens the prospect of success. The evolution of the UK economy will continue to be affected by international developments and global as well as domestic policy actions. My authorities therefore stand ready to work with others, and take whatever steps are necessary to restore non-inflationary growth and sustainable public finances. We welcome the IMF’s continued policy advice.
The Turner Review: A regulatory response to the global banking crisis, March 2009