Let me begin by expressing my authorities’ appreciation for the work of staff over the past year. As always, the Article IV team has produced an interesting and high quality set of papers, and my authorities will take careful note of their comments. And the FSAP has been a valuable exercise, providing helpful insights.

Economic Prospects

2. Growth was below trend in 2002 at 1.7% reflecting weakness in the world economy. Nevertheless, the UK was among the fastest growing of G7 and large EU economies and continues to experience the longest period of unbroken economic expansion on record. The economic fundamentals remain sound: RPLX inflation at 2.7% (1.4% HICP), interest rates at 3.75%, and employment at record levels of over 74%. With a global recovery and supportive monetary and fiscal policy, growth is forecast (in the 2002 Pre-Budget Report) to be 2½ to 3% in 2003, and 3 to 3½% in 2004. Inflation is expected to remain at, or close to, target over the next two years.

3. As the staff report notes, however, there are risks - for example, the strength of the global economy, and the possibility of a rapid unwinding of buoyant consumer demand or house prices. My authorities remain vigilant to these. They also note that output is below trend and household finances remain strong with debt-servicing costs at 20 year lows.

Policy Framework

4. My authorities believe that the strong policy framework, and the consistent and credible implementation of macroeconomic policy, have improved the resilience of the UK economy to periods of global uncertainty. So they will continue to set policy on the basis of the policy framework established in 1997, and based on the principles of transparency, responsibility and accountability:

• Fiscal policy set according to two fiscal rules:

  • the Golden Rule–over the cycle, the Government will borrow only to invest;

  • the Sustainable Investment Rule–over the cycle, public sector net debt will be held at a stable and prudent level, defined as 40% or less;

• Monetary policy set by the Bank of England’s Monetary Policy Committee (MPC), to meet a symmetric inflation target, set at 2½%, with an ‘open letter’ system should inflation move more than 1% from target either way.

5. The symmetric inflation target allows the MPC to act to support growth when inflationary pressures are weak: interest rates were lowered by 25 basis points in February 2003 in response to a weakening global outlook, and the MPC will remain vigilant and forward-looking to ensure that inflation remains at or near target.

6. My authorities have noted staffs comments on the Sustainable Investment Rule (paragraph 22). They are happy to confirm that the 40% ceiling is meant to hold at all times. They also note that the fiscal rules are widely understood by markets and others as the guiding principles of fiscal policy, and have proved very successful in anchoring expectations. They believe that stability in the framework over time promotes clarity and predictability and enhances the credibility of fiscal policy. They therefore do not favour changing the rule.

Fiscal Policy

7. My authorities agree with staff that the automatic stabilisers should be allowed to operate fully in the short term. Over the medium term, policy will remain prudent and cautious, guided by the fiscal rules. Public sector net debt has fallen from 44% in 1996/97 to around 30% in 2001/02, and is projected to stabilise at around 33% by 2007/08, as the Government borrows modestly to fund increased investment in public services. The fiscal projections show cyclically-adjusted net borrowing of around 1½% over the medium term.

8. My authorities have noted staff’s comments in paragraphs 13 and 14. However, they believe that the revenue projections are prudent and consistent with the fiscal rules. They also note the important elements of caution built into the fiscal projections:

• key budget assumptions are set at deliberately cautious levels and independently audited by the National Audit Office;

• the fiscal projections assume growth at the lower end of the forecast range;

• trend growth is assumed to be 2½%, ¼ percentage point below the neutral view;

• finally, the projections are ‘stress-tested’, by assuming (as a cautious case) trend output to be 1 percentage point lower in relation to actual output than in the central case.

9. Taken together, these give considerable protection against the inevitable risks of forecast error and unexpected shocks. And even on these assumptions (and in the cautious case) the UK meets its fiscal rules over the cycle.

Medium Term Issues

10. My authorities agree with staff on the central importance of raising productivity, and welcome the Selected Issues Paper. They have set out a comprehensive programme of microeconomic reform to remove the barriers that prevent markets from functioning efficiently. In the past year my authorities have introduced new measures, including:

• a reduction in the starting rate of corporation tax from 10 per cent to zero;

• reforms to reduce the burden of VAT and payroll administration, to simplify the tax system and reduce compliance costs for small businesses;

• a volume-based research and development tax credit for large companies;

• 2,000 Enterprise Areas in deprived areas to help businesses start up and grow;

11. In the last Article IV report staff rightly noted the legacy of under-investment in public services. Public sector net investment fell by 15% annually in real terms between 1991/92 and 1996/97 leaving the UK with the lowest level of public investment of any large EU country. To address this my authorities aim to raise public sector net investment to 2.25% of GDP by 2007/08.

12. The key issue, however, is not the level of spending but the quality of the public services delivered. My authorities agree with staff on the need to improve efficiency and effectiveness, and have set out a broad agenda for reform, based on four principles:

• clear, measurable, long-term goals, that focus service providers on the outcomes the authorities seek to achieve;

• independent audit and inspection (separating responsibility for setting and monitoring targets);

• maximum local flexibility and discretion to innovate (with additional freedoms and flexibilities as performance improves);

• transparency (through monitoring and reporting publicly against targets, including local and national comparisons).

With reforms based on these principles, and extra resources being channeled to the best performers, my authorities are determined to ensure value for money in public services.

13. Staff see greater scope for private provision of public services. My authorities see Public Private Partnerships as a key element in their strategy for high quality public services, bringing additional investment, innovation and efficiency. Staff also recommend a broader application of user fees, beyond their existing use. My authorities believe that where there is a commitment (eg. in the health service) to public services free at the point of use and available to all on the basis of need (rather than ability to pay), choice should not be promoted at the expense of equity or efficiency, particularly where there are market failures or capacity constraints. They have rejected user charges for medical or hospital care.

14. My authorities’ policy on the single European currency remains unchanged. In principle they are in favour of UK membership; in practice, the economic tests must be met. They will make an assessment of the five economic tests for membership by June of this year. The assessment will be rigorous and comprehensive, and will be published. My authorities have set out details of the preliminary and technical work which is underway, and which will be published in 18 accompanying papers. On the basis of the assessment my authorities will decide whether to recommend membership to the UK Parliament, and then to the British people in a referendum.

Financial Sector

15. My authorities welcome staff’s assessment of the UK’s financial system. The FSAP was a valuable exercise, and produced a number of helpful suggestions for further improvements which they will consider carefully.

16. They agree with staff that the financial sector is fundamentally sound and that the policy framework is strong, with a high degree of observance of standards and codes. However, they believe there is no room for complacency and are constantly seeking to develop the risk-based regulatory system to meet new challenges arising within the financial sector. On insurance, the FSA is developing proposals to strengthen supervision, to raise standards from the regular IAIS core principles (which the UK already meets) to the enhanced standards applicable to a major international centre. On anti-money laundering, a number of further improvements are being introduced through the Proceeds of Crime Act.