United Kingdom
2003 Article IV Consultation-Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the United Kingdom

The United Kingdom (U.K.) economy has weathered the global slowdown well, supported by an countercyclical monetary policy and an expansionary fiscal stance. Executive Directors welcomed this developments, and stressed the need to tighten monetary, fiscal, and macroeconomic policies. They commended the trade liberalization, the Common Agricultural Policy, the financial system, and the efforts in combating money laundering and terrorism financing. They encouraged the authorities to reintroduce momentum in the Doha round negotiations, and to increase the effective access of the least-developed countries to industrial country markets.


The United Kingdom (U.K.) economy has weathered the global slowdown well, supported by an countercyclical monetary policy and an expansionary fiscal stance. Executive Directors welcomed this developments, and stressed the need to tighten monetary, fiscal, and macroeconomic policies. They commended the trade liberalization, the Common Agricultural Policy, the financial system, and the efforts in combating money laundering and terrorism financing. They encouraged the authorities to reintroduce momentum in the Doha round negotiations, and to increase the effective access of the least-developed countries to industrial country markets.

I. Key Issues

1. The performance of the UK economy has remained strong since last year’s Article IV consultation. Growth was resilient in 2002, despite the global slowdown, and picked up during 2003, well ahead of continental Europe; investment has remained above historical levels in percent of GDP; unemployment has been stable at record lows; and inflation has stayed close to target (Figures 16).

Figure 1.
Figure 1.

United Kingdom: The Economy Has Weathered the Global Slowdown Well

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

Source: Office of National Statistics (ONS).
Figure 2.
Figure 2.

United Kingdom: Financial Markets are Pricing in an Upswing

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

Sources: Bank of England; and Office of National Statistics (ONS).
Figure 3.
Figure 3.

United Kingdom: Household Balance Sheets are Important for Consumption

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

Source: Office of National Statistics (ONS).
Figure 4.
Figure 4.

United Kingdom: The Labor Market Has Been Remarkably Resilient During the Slowdown

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

Source: Office of National Statistics (ONS).1/ Public administration, education and health which, used as a proxy for public employment.
Figure 5.
Figure 5.

United Kingdom: The Housing Market Remains Robust

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

Sources: Bank of England; Halifax; ODPM; and Office of National Statistics (ONS).
Figure 6.
Figure 6.

United Kingdom: Inflation Has Remained Close to Target

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

Sources: Bank of England; and Office of National Statistics (ONS).

Growth Rates

(year-on-year, in percent)

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

2. Economic activity benefited from supportive macroeconomic policies, in the context of clear policy frameworks. Both monetary and fiscal policies have been significantly relaxed over the last three years (see text table and Figures 79). This relaxation was received favorably by markets as it was seen as consistent with the stability-oriented monetary and fiscal frameworks introduced during the 1990s: the inflation targeting framework constraining the BoE to pursue a symmetrical inflation target through a transparent process; and the fiscal rules constraining discretionary fiscal action over the economic cycle. The strong performance of the UK economy in 2002-03 follows years of stable and high growth which benefited from comprehensive reforms of labor, products, and financial markets over the last two decades.

Comparison of Policy Stimulus: 2000-200

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Sources: ONS, EC and BEA.

From peak in 2000 to trough in 2003.

General government. Change in percentage points of GDP.

Figure 7.
Figure 7.

United Kingdom: The Monetary Policy Stance Has Been Expansionary

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

Sources: Bank of England; and Office of National Statistics (ONS).
Figure 8.
Figure 8.

United Kingdom: The Fiscal Balances are Deteriorating

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

Sources: HM Treasury, ONS, and staff estimates.1/ Including depreciation.
Figure 9.
Figure 9.

United Kingdom: Spending in Key Sectors is on the Rise

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

Source: HM Treasury

3. But key challenges remain:

  • Skeptics of the sustainability of the United Kingdom’s economic performance have pointed at the boom in house prices and household credit, which began in the late 1990s and continued in 2002–03. The presence of a possible house price bubble in the economy increases the uncertainty about consumption prospects, traditionally sensitive to house price developments in the United Kingdom, and about consumption’s response to a policy tightening. This creates particular challenges to macroeconomic policies at a juncture when the latter need to tighten to rebalance demand towards the external sector as the global economy recovers. The tightening needs to be carefully calibrated so as to steer consumption and housing markets to a soft landing.

  • The fiscal deficit should decline to strengthen fiscal fundamentals, meet the fiscal rules and support the needed monetary tightening going forward. But this decline may conflict with the authorities’ ambitious medium-term spending plans, launched in the late 1990s, unless the revenue-to GDP ratio, hard hit by the financial market downturn in recent years, recovers rapidly. Whether this will be the case is highly uncertain.


Real Residential Price Indices

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

4. These issues were at the core of the 2003 discussions. Staff also discussed structural policies for growth, financial sector issues, and the authorities’ assessment of the five tests for EMU entry published in June 2003.

II. The Discussions

A. Recent Developments and Outlook

5. After decelerating in the wake of the Iraq war, the economy is staging a strong recovery. Real GDP grew by over 2 percent in 2003, with quarterly growth rates rising above trend in the second half of the year (Tables 12). The cyclical upswing reflected not only gradually improving external conditions but also the acceleration of domestic demand. Private consumption—for years amongst the most buoyant in the OECD—after faltering in Q1, recovered during the year. This reflected: (i) stimulative monetary and fiscal policies, the latter playing a significant role in supporting the labor market and disposable income; (ii) further increases in house prices, which boosted households’ confidence and wealth, and provided collateral for increased borrowing; and (iii) continued intense bank competition for retail loans, which facilitated the rise in consumers’ unsecured debt. Business investment continued to decline (from an historically high level), reflecting sizable corporate leverage ratios and the need to plug large occupational pension deficits. The external current account deficit is estimated to have increased somewhat but, at just above 2 percent of GDP, remained close to recent averages.

Table 1.

United Kingdom: Selected Economic Indicators

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Sources: National Statistics; HM Treasury; Bank of England; International Financial Statistics; INS; and IMF staff estimates.

ILO unemployment; based on Labor Force Survey data.

The fiscal year begins in April. For example, fiscal balance data for 2002 refers to FY2002/03. Debt stock data refers to the end of the fiscal year.

Includes the auction proceeds of spectrum licenses (2.4 percentage points of GDP) in 2000/01.

Staff estimates.

As of November 2003.

An increase denotes an appreciation.

Based on relative normalized unit labor costs in manufacturing.

Table 2.

United Kingdom: Quarterly Growth Rates and Contribution to Growth

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Sources: Office for National Statistics (ONS); and staff projections.

Household Debt

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001


Corporate Balance Sheets

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

6. There was broad agreement that the recovery was likely to continue in 2004, with staff pointing, in particular, to the strong momentum of consumption. The staff’s baseline outlook projects a gradual shift of demand from domestic to external sources as the global recovery gathers pace, and exports benefit from the 5 percent nominal effective depreciation of sterling during 2003. But private consumption is projected to remain the key driver of growth through at least mid-2004, supported by the pick up in disposable income and the lagged effect of recent rises in house and equity prices.1 Later, consumption would decelerate, as the impact of (expected) higher interest rates feeds through and house price increases moderate. Staff expects business investment to rise only modestly in 2004, reflecting the same factors that hampered it last year. Overall, growth is projected to rise above trend through mid-2004—averaging 3.1 percent in the year—before settling down to potential rates of just above 2½ percent. With the external outlook improving, and sterling on average over the last year at levels regarded by staff, authorities and business representatives as sufficiently competitive, the external current account deficit was projected to edge down gradually starting in 2004 (Table 4).2

Table 3.

United Kingdom: Balance of Payments

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Sources: Office of National Statistics (ONS) and staff projections.
Table 4.

United Kingdom: Medium-Term Scenario

(Percentage change, unless otherwise indicated)

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Sources: Office for National Statistics; and IMF staff projections.

Contribution to the growth of GDP.

In percent of GDP.

CPI corresponds to the EU-standard harmonized price index. Until December 2003, the inflation target was 2.5 percent for RPIX inflation. The latter was 2.1, 2.2, 2.6 for 2001, 2002 and 2003 respectively.

In percent of labor force; based on Labor Force Survey.

Whole economy.

7. The authorities saw a more balanced composition of domestic demand, with private investment playing a more prominent role. The December Pre-Budget Report (PBR) projected a growth rebound to around 3-3½ percent in 2004, close to staff’s projections. However, business investment was expected to pick up more rapidly than in the staffs baseline. This more sanguine investment outlook relied on confidence effects, as uncertainties regarding geopolitical factors and the global recovery dissipate, and on the increasing appetite for corporate debt shown recently by capital markets. In contrast, the authorities saw consumption slowing to trend already in late 2003. Consumption indicators published after the conclusion of the discussions do not seem to confirm this earlier deceleration.


Comparison of Output Gap 1/

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

1/ OECD and EC numbers are annual average.

8. Differences, particularly between staff and Treasury, were more marked regarding the current degree of slack in the economy, with implications for growth beyond 2004. Treasury estimated the output gap at 1½ percent below potential in 2003, against the staffs ¾ percent (closer to other observers’ estimates; see text figure). Staff, in particular, stressed the low level of unemployment, which, at about 5 percent, had hardly been affected by the cyclical downturn (Figure 4). While the rise in public employment and self-employment had helped, the impact on the labor market of the reduced activity had been muffled by lower labor earnings growth, which had declined to about 3½ percent during the past two years. Thus, as the flip side of improved labor market flexibility, staff saw little room for increased labor utilization without a pickup in earnings and inflation. The Treasury representatives, however, stressed that hours worked had also declined during the downturn and this provided room for noninflationary growth. These differences of views on the current degree of slack in the economy also implied that Treasury saw room for faster noninflationary growth beyond 2004 than the staff. The PBR envisaged the output gap to close by 2006, with GDP growth of 3–3½ percent in 2005, and 2½–3 percent in 2006.

9. The near term growth outlook is subject to upside risks on the domestic front and, although fading, downside risks on the external front. On the former, consumption could turn out to be stronger, particularly as house price inflation, while declining from the 2002 peak, has recently remained high (Figure 5). On the latter, with the global recovery gathering momentum, the risks have been diminishing. However, exports could suffer from weaker-than-expected recovery in the euro area, the destination of half of UK exports, or a further depreciation of the dollar.

10. But, beyond the immediate future, there was agreement that the main risk related to a hard landing scenario of house prices and consumption. Staff noted recent cross-country evidence suggests housing price booms are followed by busts about 40 percent of the time, with a typical cumulative output loss of about 8 percent (Chapter II, April 2003 WEO). Moreover, with respect to the UK experience, there were obvious similarities between the magnitude of the current surge in house prices and household indebtedness and that of the late-1980s and early-1990s, when a crash did occur (see text figure).3 The authorities noted many things had changed since. First, the more stable macroeconomic environment, characterized by lower nominal and real interest rates, might have prompted a rise in the debt level that households can bear and, given a relatively inelastic housing supply, in the equilibrium price of houses. And, second, the abrupt interest rates hike that had pricked the early 1990s bubble was unlikely to occur in the present more credible inflation-targeting framework, and in the absence of exchange rate constraints. Rather, the symmetry of the targeting framework would allow the BoE to promptly cut interest rates in the event of a negative shock. But, the authorities concurred, risks remained. The current strength of household balance sheets was highly dependent on house prices; and information on the distribution of debt as well as liquid assets across households, while limited, indicated it was uneven, thus suggesting high exposure of some segments (Box 1). Moreover, household balance sheet adjustment in a low inflation environment would likely be slower, possibly protracting the adjustment. As to household income gearing ratios, they were low now, but, as recently noted by one MPC member, would rise significantly if rates increased as implied by the current yield curve. More generally, households’ response could be particularly sharp if a supply shock affected both inflation, prompting a rise in interest rates, and unemployment, making it difficult for households to service debt and possibly triggering a credit crunch. Altogether, staff and authorities concurred that this called for caution in calibrating monetary policy, avoiding sharp unexpected changes.


Household Debt and Real House Prices

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

Household Balance Sheets

During 2003, household balance sheets have grown further. In Q3 household debt stood at 130 percent of disposable income, a record high, reflecting rises in both secured and unsecured debt. Households’ wealth has also rebounded, to around 650 percent of disposable income (Figure 3). While the size of wealth dwarfs that of debt, the former is highly dependent on the valuation of houses. Moreover, the distribution of debt is uneven.


Household’s Interest Payments

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

A recent BoE survey on unsecured debt confirms the findings of the 2000 British Household Panel Survey (Box 2, IMF Country Report No. 03/48). During 1995–2003 the average unsecured debt to income ratio of debtors doubled. The increase between 1995–2000 was fairly wide spread across the income distribution. By contrast, the increase since 2000 has been somewhat more concentrated in households with mid to higher income. There is also some evidence that the concentration of debt among riskier borrowers has increased over time. As to the distribution of assets across households, updated survey evidence is limited. However, it appears that only 20 percent of households with high unsecured debt have financial assets compared with 40 percent in the debtor population as a whole. Moreover, based on the 2000 British Household Panel Survey, indebted households do not have larger liquid assets than the average, raising their exposure to adverse shocks.

B. Calibrating Monetary Policy

11. Inflation has been low and stable since last year’s consultation (Figure 3). The retail price index (RPIX) increased by 2.8 percent during 2003. The EU harmonized consumer price index (called CPI in the United Kingdom) rose by 1.4 percent in the same period.

12. There was broad agreement that the recent shift in the inflation target definition from RPIX to CPI would unlikely have material implications for monetary policy. Last December, with a view to facilitating convergence with the euro area, the Chancellor changed the MPC’s remit to targeting 12-month CPI inflation, rather than RPIX inflation, and because of the different statistical properties of the two indices, lowered the numerical inflation target from 2½ percent to 2 percent. Staff noted that, in principle, the new inflation target was somewhat less ambitious: over the long run, RPIX had tended to rise faster than CPI by some % percentage points, which was not fully offset by the cut in the numerical target. But this difference was modest. The current difference between the two indexes was larger (1¼ percentage point), but was due to the house price boom, and was thus expected to be temporary. As to the transparency of the inflation targeting process, the new target might complicate communication of forthcoming interest rate hikes, as CPI inflation is currently well below target. This was seen perhaps as the most significant issue by MPC members. But it was viewed as manageable, as the forward-looking nature of inflation targeting was now accepted not only by the cognoscenti but also by the public at large (Box 2).

13. Regarding actual monetary policy implementation, staff supported the recent rate increase and concurred that further increases were likely to be needed if the cyclical upswing continued. After over two years of cuts, the MPC raised rates by 25 basis points last November and again by 25 basis points in February (to 4 percent). The MPC minutes indicate that: (i) the move reflected clear signs of brighter external prospects, the observed recovery in activity, and strong credit growth (Figure 6); and (ii) interest rates would be raised further if the economy continued evolving as projected. Staff supported this approach which was in line with market expectations. First, the output gap was small, as recently stated also by the BoE Governor, and, in the staff projections, would disappear by mid-2004. Second, recently muted imported inflation was now expected to rise with the global recovery and the pass-through of sterling’s 2003 depreciation. Altogether, on current demand projections, CPI inflation was expected to edge up from the current 1.4 percent level towards the 2 percent target, and to exceed it in the absence of rate changes. In the staff’s view, the case for tightening was reinforced by the ebullience of the housing and household credit markets. On the latter point, MPC members agreed that asset price considerations should be factored into an inflation targeting framework, but views among them differed as to the extent to which this was, in practice, possible (Box 3).


Interest Rate Expectations

(in percent)

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

14. There was also agreement that a strategy of gradual, early interest rate increases was appropriate. MPC members emphasized that the uncertainties as to the likely response of consumption to changes in interest rates, related to the unusually high household debt level, called for gradualism. Staff also noted that the case for gradual—and correspondingly “early”—increases was strengthened by the risk that late and, thus, larger increases would precipitate a sharp downward adjustment in house prices. Staff also stressed that gradualism in interest rate increases would be facilitated by supportive fiscal policies.

Does the Shift from RPIX to CPI Matter?

The ¾ percentage point long term difference between RPIX and CPI inflation is due in part (½ percent) to the use by the latter of geometric averages, rather than arithmetic averages. This “formula effect” is offset by the change in the numerical target. The residual long term-difference (¼ percentage point) mostly reflects the fact that RPIX includes a distributed lag of house price increases (as proxy for house maintenance costs), which have tended to rise faster than CPI. This difference may disappear as the EU’s HICP (and hence the UK’s CPI) is broadened to include imputed rents from owner-occupied housing.


Difference between RPIX and CPI

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

The current difference is larger: 1¼ percentage point and ¾ after adjusting for the formula effect. Does it matter? Probably not.

The current difference reflects the unusually large house price inflation. But, as noted by MPC members, inflation targeting was forward looking, and house price inflation was not expected to continue at these levels. More generally, house prices were hard to predict and so their direct effect on MPC decisions had, in practice, been limited (see Box 3 for a discussion of indirect effects).

Moreover, indexation practices (of benefits, tax schedules, and interest payments) have never used RPIX anyway (but the more traditional RPI, which includes the effects of mortgage interest payments). Social partner representatives believed that agents could see through these definitional differences and that wage negotiations would not be affected either.

Asset Prices and Inflation Targeting

Asset prices may affect policy decisions in an inflation targeting framework essentially in two ways: (i) through their impact on demand via wealth and liquidity effects; and (ii) because a bubble might eventually burst possibly causing major recessionary effects on demand and inflation sometime down the road. Views across MPC members varied as to the extent to which this second channel could in practice be taken into account. Difficulties included: identifying the existence of a bubble, anticipating the effect that interest rate increases would have on it, and having to choose between facing an immediate, likely, but possibly small, inflation undershooting (if interest rates were raised to contain the bubble) and a possibly larger, but uncertain, undershooting (if rates were not raised, the bubble kept growing, and eventually burst).1

Staff acknowledged these difficulties 2 but noted that the MPC minutes had explicitly (and appropriately) referred to this second channel to justify its interest rate decisions (including in explaining the November 2003 rise).

In this respect, staff also suggested that, in order to facilitate communication of the rationale of certain interest rates decisions, the Inflation Report of the BoE could usefully discuss inflation forecasts beyond its standard 2-year horizon, as the potential effect of asset price bubbles may extend over time. The authorities acknowledged that reducing the emphasis on the 2-year horizon was in line with the inflation targeting remit (requiring keeping inflation at 2 percent at all times). But, they stressed, focusing on a single time horizon had the advantage of simplicity.

1 See, for example, “Asset Prices, Monetary Policy and Financial Stability: A Central Banker’s View” (presentation at the 2003 American Economic Association conference), by Charles Bean, MPC member.2 See also IMF Country Report 03/48.

C. Does the Fiscal Correction Require New Measures?

15. The budget position has swung from a 1½ percent of GDP surplus in 2000/01 to a projected 3½ percent of GDP deficit in 2003/04. Over two thirds of this five-percentage-point deterioration is structural (that is, unrelated to the business cycle) and reflects primarily deliberate increases in spending on public services, especially in health, education, and transport; and unexpected shortfalls in tax receipts. The latter are due to the bursting of the global equity bubble,4 and, this fiscal year, over-optimism in projecting wage growth and related taxes (Figure 8 and Table 5). Higher-than-expected spending on security and on tax credits and benefit programs has also contributed to increase borrowing, but only recently. This large fiscal expansion has been consistent with the UK fiscal framework, centered on the golden rule and the sustainable investment rule, because of the margins accumulated in the late 1990s. But these margins have been rapidly shrinking (see text figure).5

Table 5.

United Kingdom: Public Sector Budgetary Projections

(Percent of GDP and percent of potential GDP)

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Sources: National Statistics; HM Treasury; and staff estimates.

Staff estimates are based on staff’s growth projection.

Official estimates reflected in the 2003 Pre-Budget Report based on official GDP data and official GDP projections.

Capital expenditure data reported here may differ from official publications since the latter typically focus on capital expenditure net of capital receipts and depreciation.

Including depreciation.

Official data are based on official estimates and projections of potential output, and staff data are based on staff’s estimates and projections of potential output.

Sources: ONS, HM Treasury, and staff calculations.

16. Reflecting the unexpected shocks, fiscal outturns have fallen short of targets for three consecutive years, in both nominal and structural terms. This year the PBR revised the projected deficit up by about one percentage point of GDP for entirely noncyclical reasons only six months after the publication of the budget.

Budget Targets and Outcomes 1/

(In percent of GDP)

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Target as of respective budget.

Outcome for 2003/04 is PBR projection.

Based on staff estimates of potential output. The authorities’ estimates for these years are: 0.3, 1.6 and 2.4.

17. Against this background, staff and authorities concurred that a gradual and predictable strengthening of the fiscal position was needed to: (i) respect the fiscal rules going forward; (ii) improve fiscal fundamentals—the current structural primary deficit would imply a rising debt stock over time (Box 4); and (iii) support monetary tightening at this cyclical juncture, reducing the risk of large and unexpected interest rate hikes that may prevent a soft landing of consumption and the housing market. Consistently, the PBR envisaged a gradual decline of the deficit, to about 1¾ percent of GDP in 2008/09, starting with a structural adjustment of almost ½ percent of GDP in 2004/05.6 Staff regarded the latter as an appropriate target to provide a clear signal of change in course, but called for a somewhat more ambitious medium-term goal—a deficit of 1–1½ percent of GDP. Outcomes at the upper end of this range would allow net public debt to stabilize at about 35 percent of GDP, leaving room for accommodating shocks within the sustainable investment rule. The lower end of the range would reduce crowding out of private investment and provide an additional buffer against potential liabilities, particularly those from population aging. The latter were well below those of euro area countries, which justify a less tight structural fiscal target, but, while difficult to quantify, risks were not trivial (see Section E).

Fiscal Balances and Public Debt 1/2/

(In percent of GDP)

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Sources: Budget 2003, and staff projections.

Official projections based on official GDP, and staff projections based on staff’s GDP.

In fiscal years, which run from April to March.

Fiscal Sustainability

Staff’s analysis—using the standard cross-country template and taking staff projections as the baseline (Appendix IV)—shows that, on unchanged policies, public debt would keep rising, reflecting the current primary structural deficit and the cautious assumption that, on average, the interest rate on debt exceeds the GDP growth rate. Even in this case, debt financing is unlikely to be problematic over the next few years, as public debt would rise slowly and from a low level (around 32 percent of GDP in 2003 for net debt; 38 percent of GDP for gross debt).

But a correction would eventually be needed, because fiscal trends would be increasingly unfavorable as debt and interest payments rise. The more so if one allows for the fact that the debt increase may affect the yield on government securities. Indeed, there is some evidence, including econometric results controlling for differences in cyclical positions, that UK yield differentials vis-à-vis the euro-area have recently been unfavorably affected by rising relative supply of UK bonds (see figure).

18. But views differed as to whether new fiscal measures would be needed to improve the fiscal accounts.

  • In the PBR projections, the deficit improves without any new measures, reflecting: the cyclical upswing; a rebound of tax revenue related to the financial sector to levels close to the late 1990s boom; improvements in tax collection; and rising effective tax rates due to the fiscal drag (since tax brackets are uprated with prices rather than incomes). Altogether, the tax revenue to GDP ratio was projected to rise above recent historical peaks over the next few years (see text figure).

  • In contrast, staff projections indicated that without new measures the deficit would decline more modestly than projected by the authorities, both in 2004/05 and over the medium term. The gap would be about ½ percent of GDP in 2004/05, and rise gradually to 1 percent of GDP by 2008/09. In particular, staff projected lower revenue growth reflecting the lower estimate of the output gap (see paragraph 10 above), which implied a weaker cyclical rebound of revenue; and a more subdued recovery of tax receipts from financial activities, as staff saw those receipts as abnormally boosted by the financial boom of the late 1990s.7 In this baseline scenario, the golden rule would barely be met in this business cycle and the current balance would be in deficit at the start of the new business cycle. Additional fiscal risks would arise if a sharp unwinding of the house price bubble led to a period of prolonged economic weakness.


Tax Revenues 1/

(as a percent of GDP)

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

1/ PBR projections.Sources: PBR and staff calculations.

19. Staff acknowledged the substantial uncertainties associated with these projections but emphasized the need to act promptly if, as in the recent past, fiscal developments turned out to be disappointing. New fiscal slippages would increase the burden on monetary policy at a delicate juncture and the risk of triggering a hard landing scenario. Moreover, breaching the golden rule could involve a severe credibility loss for the authorities. The authorities remained confident their projections would materialize, noting that: (i) there were already signs this year that financial sector incomes were recovering rapidly; and (ii) while revenues had been overprojected during the last three years, they had been underprojected in the late 1990s, suggesting no systematic bias. In any case, they remained committed to introducing new measures if needed to meet their fiscal rules with a sufficient margin.

20. In the staff’s view, the case for fiscal adjustment, and specifically for revising the government’s ambitious spending plans, was strengthened by the risk that the latter could involve significant inefficiencies. While the expenditure policy framework had been improved—by strengthening monitoring, accountability, and incentives 8—the evidence that increased spending was bearing commensurate fruits was still scarce (as also stressed by the most recent OECD report on the United Kingdom):

  • National accounts data showed that increased public spending had been accompanied by a sharp rise in the public consumption deflator. The authorities noted that this rise was mainly related to planned increases in public sector wages, high set-up costs related to IT infrastructure, and perhaps, most importantly, problems with the proper measurement of the quality and quantity of public sector services. Staff acknowledged that mismeasurement problems could be the main cause for the rising deflator and welcomed the review launched by the statistical office to improve the measurement of public sector output. But, the possibility of supply bottlenecks could not be ruled out—especially in areas such as transportation, where measurement problems were less significant.

  • More importantly, while direct indicators of public services delivery did show some improvement since 1997, in most cases this improvement had taken place before the recent spending surge. Survey evidence also suggested a limited improvement in the population’s satisfaction with public services. The authorities explained these developments mainly with gestation lags between spending and delivery—but noted that they would continue to monitor developments closely.

Expenditure Increases Under Department Expenditure Limits (DELs)

(Real growth rates, in percent)

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Sources: HM Treasury and staff calculations

21. Staff also suggested that fiscal adjustment and efficiency could benefit from broadening the application of user fees in public services. They welcomed the initiation during 2003 of congestion charges in some cities, and the authorities’ intention to introduce variable tuition fees in higher education. However, more was needed to contain rising public sector costs, including through the introduction of user fees in the health sector.

D. Assessment of the Five Tests for EMU Entry9

22. Since the last consultation, in June 2003 the Treasury published its assessment of the five economic tests for EMU entry and concluded that the case for entry was not yet established. The UK government decided in 1997 that it would support EMU entry once the economic case for joining appeared to be “clear and unambiguous” based on five economic tests to be assessed by Treasury (see text table). The assessment published in June 2003 concluded that only the “financial services test” on whether entry would benefit the financial services industry, was considered as met. Two tests (the “investment test” and the “growth, stability and employment test,” on whether entry would be good for these macroeconomic variables), would be met only once “sustainable convergence” between the United Kingdom and the euro area was achieved. However, the two tests focusing on the existence of sustainable convergence (the “convergence test”—on whether business cycles and economic structures are compatible with those of the euro area—and the “flexibility test”—on whether the UK economy is sufficiently flexible to respond to idiosyncratic shocks (in the absence of monetary independence) were not regarded as met. In particular, Treasury highlighted that, reflecting differences in the structure of the housing and household debt markets, the UK economy was subject to idiosyncratic shocks and featured an idiosyncratic monetary transmission mechanism. Treasury, however, found that there had been significant progress in meeting the conditions for entry since the 1997 assessment. On this basis, the government has decided to take steps to facilitate euro-convergence (Box 5), and to review progress at the time of the budget in 2004.

Summary Assessment of Five Tests

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Steps to Facilitate EMU Entry

In addition to adopting the EU harmonized inflation index as monetary policy target, the government launched two reviews to identify reforms to dampen house price and consumption volatility. While final conclusions are not due until Spring 2004, the interim reports of the reviews were recently published:

The Barker Review is focusing on why UK housing supply is price inelastic. The interim report identifies several contributing factors—such as a stifling planning system and infrastructure barriers, adverse behavior of the housebuilding industry, and limited incentives for local authorities to build new houses—and discusses policy options in the areas of taxation, regulation, and subsidies.

The Miles Review is investigating why the share of long-term fixed-rate mortgages is relatively low in the United Kingdom. Its interim report concludes that the existing bias towards variable-rate mortgages is not due to institutional impediments or market failure but to poor understanding of risk and lack of information on the part of consumers. It thus calls for improved awareness initiatives.

The assessment also reiterates the government’s commitment to promote flexibility in labor, product, and financial markets, which should facilitate meeting the flexibility test, and reviews the ongoing initiatives in this area. Finally, the government opened a discussion on possible reforms of the fiscal framework that, after joining EMU, could reinforce the stabilization role of fiscal policy.

23. Staff welcomed the authorities’ extensive analyses of the economic pros and cons of EMU entry. These analyses were of very high quality and had helped clarify the issues and the authorities’ approach to them. The assessment paper and its eighteen background studies covered in great depth issues such as the benefits from entry arising from increased trade, the implications of the permanent loss of monetary flexibility, and the short-term costs of entering when cyclical conditions were different from those of the euro area. It also stressed that, given the irreversibility of entry, the authorities needed to feel confident that the case for entry had been established with a sufficient degree of certainty, and that otherwise it would be appropriate to allow more time to permit a more informed assessment. In that vein, the reform steps that the government was considering to reduce housing market volatility were not only consistent with the goal of EMU entry but appropriate in their own merits.

24. Looking to the next assessment of the five tests, staff suggested that further attention could be given to some difficult, yet critical, issues. In particular, the recent assessment had taken the view that the large potential long-term gains from entry (arising essentially from increased trade) would materialize only if the United Kingdom entered once a sufficient degree of convergence had been achieved. However, further empirical work would be helpful in quantifying the effect of insufficient convergence on those long-term gains. On another plane, while agreeing that further structural reforms to enhance flexibility were in any case desirable, more could be done to explain the benchmarks by which flexibility should be regarded to be sufficient (the recent assessment regarded flexibility insufficient in spite of the progress made since 1997 from an already enviable position). Finally, more attention could also be paid to evaluating some costs of postponing entry. A more complete treatment of these issues would strengthen any conclusion reached by the next assessment.

E. Structural and Financial Sector Issues

25. The authorities’ approach to ensuring adequate pensions remains centered on a high and increasing role of private pension schemes as the population ages. Current and future public pension obligations are modest compared with most other European economies. This reflects less unfavorable demographics and higher reliance on private pension schemes, as public pensions are expected to provide only basic pension benefits, and are partly means tested.10 Official projections indicate that public pension spending will remain stable at about 5-5½ percent of GDP over time, as overall age-related spending needs increase by 3½ percentage points of GDP by 2050. In the same period, the share of pensioners’ income from private sources is projected to rise from the current 40 percent to 60 percent.

26. However, the financial (and political) viability of this system depends crucially on whether people are saving enough for retirement; this is far from clear.11 Over the past few years, the authorities have enacted several measures with the goal of fostering private savings through new saving vehicles—e.g., new easy-to-transfer standardized pension and saving products aimed at low- and middle-income sectors. But some recent developments have raised concerns. These include indications that pension-related saving, particularly among low-income sectors is too low; financial difficulties experienced by the life insurance industry; and significant deficits in some company-sponsored occupational pension schemes. Staff noted that these developments, if not corrected, may involve sizable future liabilities for the fiscal accounts (as pressure for widening the benefits provided by the state would rise, and as more people would qualify for means tested benefits). A proactive approach was thus required to assess the performance of the current strategy and change course if needed. In this regard, they welcomed the establishment of an independent Pension Commission, entrusted with assessing the need for further reforms, including the potential advantages of strengthening compulsory saving elements in the system.

27. Another key structural challenge is raising UK productivity—which lags about 20 percent behind other comparable economies.12 Although the evidence is still unfolding, the gap with respect to the United States appears to be rooted in lower research and development spending, weaker managerial practices, and shortcomings in the competitive environment. Lower workforce skills and capital stock could explain the gap with respect to the leading continental European economies. The authorities have responded with a multi-pronged approach with initiatives addressing all key drivers of productivity: competition, enterprise, science and innovation, skills, and investment.


Comparison: Output per Hour

(Average 1992-2002)

Citation: IMF Staff Country Reports 2004, 056; 10.5089/9781451814187.002.A001

28. While staff reiterated its support of recent initiatives in these areas, it saw a need for systematic monitoring and evaluation of ongoing programs. This would allow for the retirement of unsuccessful initiatives, the extension of successful ones, and a targeted prioritization over time. The extension of the R&D tax credit to all corporations and the expansion of training programs reflect good reception by the business community and positive appraisals by independent evaluations and researchers. But initiatives in this area have proliferated in recent budgets and the strategy could benefit from a pruning of programs. Discussions also focused on the institutional setting for promoting competition which had been substantially reinforced in recent years by expanding the powers and independence of the Competition Commission and the Office of Fair Trading. The implementation of the Enterprise Act in June 2003 culminated this phase of reform of the system, with the emphasis now shifting to ensuring its effective operation.

29. Programs for further enhancing the already high employment rate may also need closer monitoring. Both authorities and independent analysts indicated that some of the active labor market policies concentrated around the New Deal programs, particularly those targeted at the unemployed aged 18-24, had been successful. Staff welcomed the announcement in the PBR of plans to enhance this approach for those aged over 24. But the effectiveness of other New Deal programs aimed at incorporating specific groups into the labor market was still to be demonstrated. Some of these programs may need stronger job search incentives.

30. Overall, the UK financial system has proved resilient to the global slowdown and is set to benefit from the ongoing recovery in growth and stock markets.

  • Banks’ profitability and capitalization levels remain high. Going forward, the mix of risks will evolve with changes in the macroeconomic environment. As the 2002 FSAP indicated, banks’ portfolios may experience a deterioration as a result of higher interest rates and significant declines in property prices, given the high levels of household and corporate indebtedness. However, banks’ high profitability and capitalization levels should allow them to absorb likely macroeconomic shocks without systemic distress.13 Over the medium term, the ongoing trend compression of margins owing to increased competition in retail banking may dampen profitability as credit growth decelerates.

  • The insurance industry has been under considerable stress in recent years. Conditions have now stabilized and capitalization has improved, including through resort to capital markets. The sector has also benefited from the rebound in equity markets in 2003. But, as documented in the FSAP, weaknesses remain—although the authorities indicated that they affected mostly firms with little systemic impact. The ongoing reform of insurance regulation by the FSA aims to apply a risk-based framework (now primarily used for banking supervision) to the insurance industry. When implemented, it will strengthen the sector and minimize the risks of systemic stress.

  • The authorities have also further strengthened the procedures and institutional arrangements of the payment and settlement systems with a view to enhancing their efficiency and minimizing settlement and counterparty risk.

F. Other Issues

31. The United Kingdom has consistently supported trade liberalization within the context of EU membership. Staff welcomed the authorities’ intention to press for resuming negotiations under the Doha round and for further flexibility in the EU on the “Singapore issues” (investment, competition, government procurement, and trade facilitation) in the context of the round. The authorities also reiterated their support for CAP reform. They thought there was room for going beyond the Commission’s proposal in some areas (for example, they would prefer a higher level of compulsory decoupling for cotton and olive oil, and a more liberalized regime for sugar with prices closer to world levels). They also indicated that the UK, after the 10-year transition phase, was ready for the elimination of the quota regime for textiles and clothing (the “multi-fiber arrangement”), except for some small businesses. Regarding less developed countries’ access, the United Kingdom was advocating that the European Commission review its Rules of Origin requirements to ensure that the intended countries would be able to take full advantage of current preferential agreements, such as the Everything-But-Arms initiative.

32. The government has continued strengthening the legal framework to combat money laundering and the financing of terrorism (AML/FT). The anti-money laundering provisions of the new Proceeds of Crime Act were implemented in February 2003 expanding AML coverage and reporting obligations—which the authorities are extending further to accountants, lawyers, and other relevant agents, as recommended by the FATF, through new AML regulations coming into force on March 1, 2004. This completes the implementation of the Second EU Money Laundering Directive. The OECD Bribery Working Group considers that UK legislation addresses the requirements of the OECD Anti-Bribery Convention.

33. The United Kingdom is committed to increase ODA from 0.32 percent of national income in 2002/03 to 0.4 percent in 2005/06, with the final goal of achieving the United Nations target of 0.7 percent.

III. Staff Appraisal

34. The UK economy has weathered the global slowdown well, supported by an appropriately countercyclical monetary policy and an expansionary fiscal stance. Growth has been resilient relative to other industrial countries, inflation has remained close to target, and unemployment has been low and stable. Crucial to this performance, macroeconomic policies have been expansionary without undermining confidence—owing to well established and transparent monetary and fiscal policy frameworks with a distinct medium-term orientation. The driving force has been domestic consumption, supported by continued increases in house prices and household debt. This strong performance also reflected structural factors, including the flexibility of labor, product, and financial markets which have been deeply reformed over the last twenty years.

35. With the external environment improving, and continued strong momentum of domestic demand, the growth outlook remains favorable. The pace of consumption continues to be strong, but is expected to moderate during 2004, as the impact of higher interest rates feeds through, thus making room for the projected strengthening of external demand. Overall, growth is projected to remain above trend at 3 percent in 2004 before settling down to potential rates of around 2½percent.

36. The main risk to this outlook stems from an abrupt correction in housing and credit markets. In the immediate future, given its strong momentum, the risks for consumption and output growth are still on the upside. But, further out, the possibility of a reversal remains. House price and household debt developments in recent years are reminiscent of those of the late 1980s, whose reversal contributed to the early 1990s recession. Admittedly, the overall structural conditions of the UK economy, including its policy frameworks—albeit untested in a period of major stress—are considerably stronger than in the early 1990s. But, in the presence of considerable uncertainty on the distribution of asset and liabilities of households, and on the latter’s exposure to a sharp rise in interest rates and unemployment, the possibility of a disruptive correction cannot be ruled out. To minimize these risks, cautious macroeconomic policies are needed.

37. In the fiscal area, the deficit needs to be kept on a predictable adjustment path. The deficit has widened rapidly, including in structural terms, in the last three years, exceeding every year the initial budget projection. Lowering the deficit from the 3½ percent of GDP projected for 2003/04 is needed to meet the fiscal rules, strengthen fiscal fundamentals, and support monetary policy during the cyclical upswing. An adjustment of ½ percent of GDP in the structural deficit already in 2004/05, in line with the PBR projections, would provide a visible signal of change in course. The adjustment in the structural position should continue in later years, with the goal of lowering the structural deficit to 1-1½ percent of GDP over the medium term. The upper bound of this range would stabilize public debt at around 35 percent of GDP, leaving a reasonable margin under the 40 percent of GDP debt ceiling; the lower bound would allow an additional margin to face future contingent liabilities, including those from population aging, and involve a lower crowding out of private investment. The automatic stabilizers should be allowed to operate fully around this adjustment path.

38. But the authorities’ fiscal projections are subject to considerable risks and additional measures will likely be needed. The PBR projects the deficit to fall along a path only slightly less ambitious than indicated above in the absence of measures, reflecting a sharp recovery in revenues. But under staffs more conservative assumptions, the deficit on current policies would decline to only 2¾ percent of GDP over the medium term—1 percentage point above the PBR projections—only a modest adjustment with respect to the current level, with a gap already emerging in 2004/05. Thus, the authorities should follow developments closely and take corrective actions promptly, if needed. New fiscal slippages should be avoided as the risk of breaching the golden rule would not be trivial and as slippages would involve excessive strain on monetary policy in a delicate cyclical phase.

39. Moderating the ongoing steep escalation in spending would limit the risk of inefficiencies and help fiscal consolidation. The authorities have continued strengthening the expenditure management framework. However, there is not yet enough evidence that increased spending is producing value for money. A slower spending pace would provide room for assessing better whether the new procedures set in place to guarantee efficiency are working. Likewise, a wider resort to user fees for public services would help rationalize demand and reduce strains on the budget.

40. Monetary policy should continue to tighten to contain the pace of domestic demand as the external outlook improves, and facilitate a soft landing scenario. With the estimated output gap small, recovery momentum building, and the restraining effects of low import price inflation receding, CPI inflation is set to rise gradually above target. This calls for raising rates preemptively. The case for tightening is reinforced by the ebullience of the housing and household debt markets.

41. An “early but gradual” strategy of rate increases is needed. The increased sensitivity of the debt servicing burden to base rate changes, the potential vulnerability of a segment of borrowers to rate hikes, and, more generally, the increased uncertainty on the response of consumption to interest rate increases call for gradual, and correspondingly early, increases in rates. Against this backdrop, the November and February rate hikes of 25 bps were appropriate. Looking ahead, if and as the baseline unfolds, rates should steadily be raised in small steps.

42. The MPC’s forward looking approach is well-equipped to deal with the challenges posed by the change in the inflation target. With CPI inflation running well below its new target, the change seems to pose a greater challenge for monetary policy in communicating rate hikes. But, the forward looking-orientation of monetary policy, focused on inflation forecasts rather than outcomes, is now broadly accepted and provides a strong basis for explaining the need to raise rates preemptively in a cyclical upswing.

43. A key challenge is to ensure adequate provision of pensions as the population ages. The authorities’ approach to facing the challenge of population aging, centered on the goal of raising the share of pensioners’ incomes from private sources, remains appropriate. But the viability of this approach depends on whether people are saving enough and indications are that this may not be the case. This increases the risk that public pension liabilities may be higher than currently projected. The establishment of a Pension Commission, in charge of monitoring developments in this area and recommending corrective actions if needed, is thus appropriate.

44. The publication of Treasury’s assessment of the five tests for EMU entry is welcome. It clarifies the government’s position and represents a major analytical contribution to the debate on this critical decision. The next assessment could benefit from further work on some difficult issues that are key to the entry decision (such as the long-term implications of entering before full convergence has been attained, the benchmarks to be used to assess whether flexibility is sufficient, and some costs of delaying entry). Among the initiatives launched by the authorities to follow up on the assessment, the reviews of the working of the housing and household debt markets are particularly timely.

45. The authorities’ policy agenda to boost productivity and promote employment properly encompasses a variety of fronts, but should be reassessed regularly. This would allow streamlining or scrapping ineffective programs. Some active labor market initiatives, such as the New Deal for 18-24-year olds, have succeeded, partly because they strengthened job search incentives. Other New Deal programs would benefit from a similar strengthening. The various ongoing initiatives to boost productivity should also be monitored closely with the goal of streamlining them as needed.

46. As reported in the 2002 FSAP, the UK financial supervisory framework is in many aspects at the forefront internationally and the banking system is sound. Looking forward, the possibility of a decline in mortgage collateral values deserves special vigilance. Also, as credit growth decelerates, compressed margins may erode profitability—although from high levels. The current reform of insurance supervision and regulation will strengthen the sector and minimize the risk of future systemic stress. Reforms in the settlement and payment systems have further reinforced their safeguards and efficiency.

47. The United Kingdom’s strong stand in favor of trade liberalization is commendable. Efforts to reform CAP, reintroduce momentum in Doha round negotiations, and increase the effective access of less developed countries to industrial country markets should be maintained. While the ongoing increase in ODA spending is welcome, the UN target of 0.7 percent of GDP remains distant.

48. The further strengthening of the United Kingdom’s AML/FT legislation is welcome.

49. It is proposed that the next Article IV consultation be held on the standard 12-month cycle.

APPENDIX I United Kingdom: Basic Data

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Sources: National Statistics; HM Treasury; and IMF staff estimates.

As of 2003Q3.

As of November 2002.

Includes 2.4 percentage points of GDP in 2000/01 corresponding to the auction proceeds of spectrum licenses.

Fiscal year beginning April 1.