United Kingdom
2005 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’s 2005 Article IV Consultation reports that macroeconomic performance has been strong and steady, owing in part to confidence-enhancing policy frameworks and generally sound implementation. The financial system is generally healthy, although a substantial increase in the pricing of risk would pose risks. The banking system is well-capitalized and highly profitable. The health of the insurance sector has improved substantially. Credit risk transfer instruments are helping to diversify credit risk, but their rapid growth may also be creating new risks.

Abstract

The United Kingdom’s 2005 Article IV Consultation reports that macroeconomic performance has been strong and steady, owing in part to confidence-enhancing policy frameworks and generally sound implementation. The financial system is generally healthy, although a substantial increase in the pricing of risk would pose risks. The banking system is well-capitalized and highly profitable. The health of the insurance sector has improved substantially. Credit risk transfer instruments are helping to diversify credit risk, but their rapid growth may also be creating new risks.

I. Overview

1. Macroeconomic performance in the U.K. over the past decade has been strong and steady. Between 1995 and 2004, the growth of real GDP per capita was higher and less volatile than in other G7 countries. Unemployment and inflation were low and stable, and the current account deficit was moderate. This impressive performance was due in part to confidence-enhancing frameworks for monetary, fiscal, financial, and structural policies, as well as generally sound implementation (Box 1).

uA01fig01

Growth of Real GDP Per Capita, 1995-2004

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

1/ Standard Deviation (inverted scale).

Fund Policy Recommendations and Implementation1

Fiscal policy: For several years, the Fund has pressed for policy measures to narrow the large fiscal deficit and ensure that the fiscal rules are met. While the proposed adjustment was not initiated immediately, better-than-expected oil and personal income tax revenue performance and recent commitments have narrowed the gap between policy and Fund advice. The Fund and the authorities share the view that the rules-based fiscal framework has constrained discretion and allowed automatic stabilizers to operate. In the past year, the authorities broadened the scope of independent audit of the budget assumptions, as recommended by the Fund.

Monetary policy: The Fund has praised the inflation targeting framework for its overall design and consistently strong implementation.

Financial stability: In line with the recommendations of the 2002 FSAP, the authorities have enhanced their surveillance of the financial system, improved the supervision of insurance companies, and strengthened payment and settlement systems.

Structural policies: The Fund has supported the authorities’ strategies to boost productivity growth, increase labor force participation, and encourage housing supply.

1/ The latest Public Information Notice is available at http://www.imf.org/external/np/sec/pn/2005/pn0527.htm

2. However, in 2005, policymakers faced their toughest challenges in several years. The slowdown in real GDP growth and the rise in inflation were sharper than in other G7 countries, presenting a dilemma for monetary policy. The deterioration in the general government balance between 2000–04 was greater than in other G7 countries, so the fiscal deficit was large coming into 2005. While the health of the U.K. banking system compares favorably with that in other G7 countries, the possible reversal of unusually low long-term interest rates in global financial markets poses a risk to the U.K., given the size of its financial sector. Over the very long term, the political sustainability of the U.K.’s relatively frugal state pension system depends on workers saving enough for retirement, but evidence suggests that they are not doing so.

uA01fig02

Change in Real GDP Growth, 2004-05

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig03

Change in Average CPI Inflation, 2004-05

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

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Change in General Government Balance, 2000-04 1/

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

1/ calendar year.

II. Background

3. Slowing growth and rising inflation in 2005 reflected the U.K.’s advanced cyclical position, the abrupt deceleration in house prices, and the sharp increase in oil prices (Table 1). With economic activity above potential in 2004, some easing of growth and rise of inflation were expected. In the event, the slowdown, which may be overstated in the current national accounts data, was sharper than expected.1 It was driven primarily by private consumption, which reflected previous monetary policy tightening, the cooling of the housing market, and rising tax revenues (Box 2). In line with the deceleration in the increase of house prices, the growth of residential investment fell sharply; business investment growth was steady. As domestic demand decelerated, import growth slowed, but a drop in net services inflows (due in part to insurance payments related to Hurricane Katrina) led to a slight widening of the current account deficit. Employment growth remained surprisingly rapid, owing in part to strong supply effects (immigration and increased labor force participation by older people). The rise in CPI inflation reflected both the earlier testing of supply constraints and the sharp increase in energy prices.

Table 1.

United Kingdom: Selected Economic and Social Indicators

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Sources: National Statistics; HM Treasury; Bank of England; International Financial Statistics; INS; World Development Indicators; 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 using centered-GDP as a denominator.

Average. An increase denotes an appreciation.

Based on Consumer Price data.

As of November 2005.

uA01fig05

Nominal House Prices

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig06

Household Interest Payments and Policy Rate

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig07

CPI and Core CPI

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig08

Services Inflation and the Output Gap

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

Consumption and Housing Wealth

The cooling of the housing market over the past year can explain part of the recent weakness in consumption. Staff have re-examined the relationship between consumption, disposable income, unemployment, interest rates, financial wealth, and housing wealth, using data from 1987 (after financial liberalization)–2005.1 An error-correction model suggests that a 10 percent increase in housing wealth boosts consumption by about 0.7 percent in the long run, though the uncertainty surrounding this estimate is large.

The model captures well the slowdown in consumption growth between mid-2004 and mid-2005. A counterfactual exercise suggests that—if real housing wealth had continued to rise by about 2 percent per quarter (the average in 2003) instead of flattening out—quarterly consumption growth would have been higher by about ¼ percentage point. Looking forward, if house prices grow less quickly than nominal GDP, the household saving rate is likely to rise further.

uA01fig09

Consumption Growth

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

1/ Selected Issues Paper, The Link between Private Consumption and the Housing Market.

4. The lowest growth rate and highest inflation rate since BOE independence presented monetary policy with conflicting signals. In the early part of this decade, the desirable direction of monetary policy changes had been more straightforward: loosening during the downturn of 2001–02 and tightening again as growth picked up in 2003–04. In 2005, by contrast, monetary policy confronted a simultaneous slowdown in aggregate demand and a sharp rise in energy prices. The latter produced an increase in the overall price level and the risk of second-round effects on inflation. A further consideration was the strength of immigration, especially from new EU members, which may have boosted labor supply relative to demand for goods and services. The only policy rate change in 2005 was a ¼ percentage point cut to 4% percent in August.

uA01fig10

Growth and Inflation 1/

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

1/ Projections for 2005.

5. After having a strongly countercyclical influence during FY2001/02 and FY2002/03, fiscal impulses were procyclical in FY2003/04 and FY2004/05.2 Over much of the past decade, fiscal policy managed to contain—even reduce—debt while playing a useful countercyclical role; fiscal consolidation during the boom of the late 1990s was followed by fiscal expansion during the downturn of the early part of this decade. However, the sharp increase in government spending on public infrastructure and public services that began in FY2000/01 continued in FY2003/04—FY2004/05. The result, as growth picked up, was a procyclical stimulus, a growing deficit, and a rising debt ratio. Yet, with low debt compared to other G7 countries and a benign international environment, interest rates on government debt remained low.

uA01fig11

Fiscal Balance

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig12

Net Public Debt 1/

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

1/ Includes one-off receipts from the sale of mobile telephone licenses (2.3 percent of GDP) in FY2000/01.
uA01fig13

Current and Capital Expenditures

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig14

Net Debt, 2004

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

6. The U.K. banking system is strong, though the possible reversal of the low yield environment in global financial markets poses a risk. Given the U.K.’s role as a global financial center, financial stability has potentially far-reaching implications beyond its borders. Ratings agencies continue to rank the U.K. banking system as one of the strongest among G7 countries. However, over the medium term, increasing leverage and the continuing search for yield represent downside risks. These risks, while global, are particularly relevant for the U.K. given the size and openness of its financial sector: its banking system, insurance sector, and financial markets are among the largest in the world.

uA01fig15

Banking System Quality Indicator

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

Source: Fitch Ratings.

7. A longer-term question is whether private saving is adequate to support an aging population in the context of a frugal state pension system. Prima facie, long-term fiscal sustainability in the U.K. is helped by less severe population aging and a less generous state pension system than in other G7 countries. However, if the working generation does not save enough for its own retirement, future governments may be forced to increase state pensions. A year ago, a government-appointed, but independent, Pensions Commission concluded that almost half of the working age population over 35 (mostly middle-income earners) is not saving enough to meet likely expectations of retirement income. The report found that the main obstacles to higher private saving are the complexity of the pension system, disincentives from means testing, the high cost of private pension products, and the difficulty of making rational decisions about long-term saving.

uA01fig16

Increase in Old-age Dependency Ratio

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

Source: UN.
uA01fig17

Net Replacement Rates 1/

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

Source: OECD.1/ Ratio of pensions to average earnings, net of taxes and social security contributions.

III. Report on the Discussions

A. Introduction

8. The authorities and staff broadly agreed that policies were successful in the difficult environment of 2005 and are well-positioned to ensure strong performance in the future. Real GDP growth is expected to pick up in 2006–07 and CPI inflation to settle at the 2 percent target. Monetary policy continues to anchor inflation expectations at the inflation target. The financial sector is well-regulated and well-supervised and the outlook for the sector is favorable, though supervisors are keenly aware of risks in the present global environment. The authorities were confident that, with recently-announced initiatives, fiscal policy will contain debt over the medium term below the 40 percent ceiling and keep the current budget in balance over the officially-projected economic cycle. For the long term, the authorities were less convinced than the Pensions Commission that private saving is inadequate but welcomed the debate started by its final report, released just prior to the mission’s arrival. The mission focused on four main questions:

  • How is the government responding to persistent large fiscal deficits, which—if unchecked—would pose a threat to the fiscal rules?

  • How robust is the emerging recovery and how will it change the balance of risks from weak demand growth and high energy prices in the BOE’s assessment?

  • How are the supervisory authorities addressing the possibility that low long-term interest rates may reverse?

  • How much of a problem is low household saving for retirement and how could shortfalls be remedied given limited public resources?

B. Economic Outlook

9. A gentle pickup in economic growth is likely (Tables 2 and 3). In line with the projections presented by officials at the Treasury and the Bank of England, staff expect that real GDP growth will rise to 2½ percent in 2006 and 2¾ percent in 2007. This assumes a continued favorable external environment. Private consumption growth, supported by continued robust employment growth, is expected to return close to trend as the adverse effects of rising debt service and energy prices, as well as of the deceleration of house prices, wane. Business investment growth is projected to rise modestly, underpinned by robust profitability, ample liquidity, and benign financial market conditions. The size of the increase will be dampened, however, by continued high leverage and pension deficits, as well as the ongoing adjustment to higher energy prices. Export growth is projected to remain strong, in line with robust global growth, while import growth should pick up modestly in line with domestic demand. CPI inflation is expected to fall slightly below the 2 percent target during 2006, as the effects of higher oil prices and previous pressures on capacity wane, and then rise to target during 2007, as output growth picks up and import prices increase.

Table 2.

United Kingdom: Quarterly Growth Rates

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

Contribution to the growth of GDP

Table 3.

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.

In percent of labor force, period average; based on the Labor Force Survey.

Whole economy, per worker.

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.

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

10. The Treasury’s estimate of the output gap in 2005—which matters for the fiscal projections—is considerably larger than those of other forecasters, including staff. Officials pointed to the slowdown in average earnings growth and increase in jobless claims during 2005 as evidence of sizable labor market slack. Staff agreed that there had been an increase in slack in 2005. But economic indicators (including continued strong employment growth, the small rise in the unemployment rate, the small size of the decline in average earnings growth, and about average readings on survey measures of capacity utilization) and production-function-based estimates of the output gap suggested only a small degree of excess capacity, in line with the view of the BOE and most private analysts. Staff observed that the Treasury’s estimate of the output gap indicates excess capacity from 2001 to 2008, a remarkably long period for an economy that is generally regarded as being quite resilient.

uA01fig18

Output Gap

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

11. The negative international investment position (IIP) and current account deficit are not major concerns. The U.K.’s role as an international financial center implies large gross external assets and liabilities, much larger (as a share of GDP) than in any other G7 country. As a result, valuation changes have big effects on the IIP, usually bigger than flow effects; the standard deviation for both net portfolio investment and net foreign direct investment is about 10 percent of GDP (Appendix IV). Specifically, the fall in the IIP over the past two years was mostly due to sterling appreciation against the U.S. dollar. The authorities and staff expected the substantial surplus on investment income in the current account to persist, noting that the U.K. earns more on its assets (especially foreign direct investment) than it pays on liabilities (mostly debt). The deficit on trade in goods and services is projected to remain steady relative to GDP over the medium term, given strong growth in trading partners, a stable share of U.K. exports of goods and services in G7 exports (over time, the increase in the services share has been offset by a decline in the goods share), and continued steady effective exchange rates (Table 4). While noting that exchange rate assessments have significant margins of uncertainty, staff observed that the latest CGER exercise suggests that sterling is 0–15 percent above its medium-term equilibrium on a multilateral basis. Officials concurred that there is not strong evidence of overvaluation and that the floating exchange rate system is satisfactory.

Table 4.

United Kingdom: Balance of Payments

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Sources: Office of National Statistics (ONS) and staff projections.
uA01fig19

Net International Investment Position

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig20

U.K. Export Share

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig21

Effective Exchange Rates

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

12. Large uncertainties, however, surround prospects for both demand and supply:

  • Staff suggested that house prices are likely still overvalued, noting the elevated ratios of house prices to average earnings and of house prices to rents. BOE officials observed that estimates of overvaluation are highly sensitive to the level of real interest rates—an increase in interest rates would significantly increase estimates of overvaluation. However, the degree of estimated overvaluation is tempered by the growing number of households, constraints on housing supply, and the stabilization of house prices over the past year (in contrast to the sharp decline during the early 1990s). Officials and staff concurred that house price increases are unlikely to exceed nominal GDP growth over the medium term. In the short term, however, forward-looking indicators of housing market activity suggest a pick up in house prices.

  • The sharp increase in energy prices to date has raised the inflation rate and will likely reduce aggregate supply. Staff analysis suggests that the doubling of energy prices between end-2003 and end-2005 led to a peak first-round effect on inflation of about ¾ percentage point and will cause a cumulative loss of output of about 1 percent, spread over 2006–08 (Box 3). BOE officials noted that their analysis indicates the need for a fall in the real consumption wage of about 1½ percent. Staff cautioned that, because the rise in energy prices has only recently come to be seen as permanent, adverse effects on potential output are still likely. Any further price increases would have negative consequences for growth and inflation.

  • Officials and staff concurred that significant immigration has likely helped to alleviate specific skill shortages and thus acted to relieve inflationary pressures. However, the magnitude and persistence of supply effects are difficult to judge. Given the lack of reliable statistics, officials offered different views on the extent to which increased immigration is a new phenomenon. Some argued that it has been apparent for a while, for example in the reports of the BOE’s regional agents. Others, however, pointed to an increase in immigration following the relaxation of border regulations in May 2004 to allow new members of the EU full access to the U.K. labor market. The latter argued that the number of additional migrants could well be about 100,000 (about ¼ percent of the working-age population). The net impact on economic slack depends on migrants’ effect on aggregate demand, but it is likely to be positive. Going forward, immigration from new EU members could slow (if the stock adjustment has already largely occurred) or rise (as migration pathways become more established). In either case, labor supply will likely be more elastic than in the past.

  • Officials acknowledged risks of a sharp change in exchange rates, but thought that they were low probability. A disorderly resolution of global imbalances could result in exchange rate appreciation, although—in the past—sterling appreciation against the U.S. dollar has been largely offset by depreciation against the euro. In contrast, further increases in US and euro area short-term interest rates (combined with roughly unchanged U.K. rates) could put downward pressure on sterling.

uA01fig22

House Price to Rent Ratio

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig23

Real House Price Growth

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig24

Mortgage Approvals and House Price Growth

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

C. Monetary Policy

13. The combination of slowing house price appreciation and rising energy prices was a challenge for monetary policy in 2005. Members of the Monetary Policy Committee (MPC) had different perspectives on the extent to which the cooling housing market was a cause rather than a symptom of the economic soft patch. They agreed, however, that the weakness of aggregate demand in 2005 had—other things equal—raised the question of whether monetary policy easing was needed. At the same time, the boost to inflation from higher energy prices had risked affecting inflation expectations, suggesting the need for caution in cutting interest rates. Supporting the MPC’s decision in August 2005 to cut the policy interest rate by ¼ percentage point to 4½ percent, staff agreed that it had been a finely balanced one.

uA01fig25

U.K. Policy Rate and 10 Year Government Bond

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

The Impact of Higher Energy Prices on Growth and Inflation

Oil prices roughly doubled between end-2003 and end-2005. The evolution of futures prices suggests that expectations of the permanent component of the price increase rose gradually over that period. Using a variant of the Fund’s Global Economic Model incorporating energy (oil and natural gas), staff estimate the impact on the U.K. economy of this price shock.1

uA01fig26

Oil Prices Spot and Futures

(percent deviation from $29 per barrel)

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

The simulation results suggest that the impact on GDP was small in 2004–05. The terms of trade effect was slightly positive, given the U.K.’s small net exports of energy, while the initial decline in domestic demand was modest, because a large portion of the price increase was expected to be temporary. However, looking ahead, the negative effects on both demand and supply are projected to grow over the next three years to about 1 percent. The adverse supply impact is due to firms’ adjustment to the permanent increase in a factor cost, while the negative demand effects reflect households’ realization that their real incomes will be permanently lower and firms’ reduced demand for investment goods. Over time, the positive effect on energy production is more than offset by the adverse impact on non-energy output.

The results suggest that about half of the 1½ percentage points rise in CPI inflation between September 2004 and September 2005 was due to the energy price shock. Inflation should fall back to baseline quickly, as long as three conditions hold: the reduction in the economy’s supply capacity is fully recognized in monetary policy, labor suppliers accept the permanent reduction in their real wages, and energy prices do not increase further.

uA01fig27

Real GDP

(percent deviation from baseline)

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig28

CPI Inflation

(percent deviation from baseline)

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

1 Selected Issues Paper, The Impact of Rising Energy Prices.

14. Most MPC members and staff considered the current stance of monetary policy to be appropriate. In the BOE’s—and staff’s—baseline projections, CPI inflation is expected to reach the 2 percent target at the 2-year horizon, assuming no second-round effects from oil prices, a narrowing of the small output gap, continued increases in import prices, and well-anchored inflation expectations. The spread between nominal and RPI-indexed bond yields is stable at 2¾ percent, consistent with the CPI target of 2 percent.3 Some MPC members were concerned about downside risks to the growth forecast and the minutes of the MPC meeting immediately preceding the mission showed that one MPC member felt that rates should be lower. The authorities and staff saw the current policy rate as broadly within a neutral range, though some MPC members characterized it as mildly accommodative.

uA01fig29

Inflation Expectations over 10 Years

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

15. The flat yield curve reflects low long-term interest rates rather than tight monetary policy. The decline in long-term rates over the past year could be due to a variety of factors, including a fall in the risk premium (possibly reflecting the entrenchment of macroeconomic stability), increased household saving for retirement, and a portfolio shift toward long-term bonds (especially by pension funds). More generally, low long-term rates are a worldwide phenomenon, likely reflecting a combination of high desired saving relative to desired investment and a possible under-pricing of risk.

16. The next policy move should depend mainly on wage developments and evolving evidence on strengthening demand, an approach staff supported. Some MPC members saw avoiding second-round effects from higher energy prices as the priority, while others were more concerned about prospects for a recovery of demand growth. Thus far, there is no sign that workers are resisting the decline in the real consumption wage implied by higher energy prices, with average earnings growth subdued and pay settlements steady at their recent historical average. However, many wage negotiations are traditionally concluded in the early part of the year, so it will be important to monitor them for evidence of real wage resistance. At the same time, with a rebound in consumption already underway, MPC members would be looking for evidence that other components of demand—notably business investment and exports—are picking up as envisaged in their baseline projections. Staff observed that opposing effects on aggregate supply from higher energy prices and increased immigration would also influence prospects for inflation. An important medium-term consideration is whether the government will deliver on promised expenditure restraint starting in 2008, potentially producing a negative fiscal impulse. The authorities noted that this is still beyond the 2-year horizon relevant for monetary policy decisions.

uA01fig30

Private Sector Average Earnings, excl. bonus

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

D. Fiscal Policy

17. The expected improvement in the fiscal balance in FY2005/06 is the beginning of a planned medium-term reversal of recent large deficits (Table 5). The December 2005 Pre-Budget Report (PBR05) projects a reduction in the cyclically-adjusted overall deficit relative to GDP of ¾ percentage point in FY2005/06. The cyclically-adjusted current deficit is expected to narrow even more, given the projected increase in capital spending. The two main factors behind the improvement are higher tax revenues from North Sea energy production and higher tax revenues from the financial sector, reflecting a combination of the continued strength of global financial activity, the relatively high effective tax rates on financial sector incomes, and anti-avoidance measures. Staff concur with the changes in the cyclically-adjusted balances in FY2005/06 relative to FY2004/05, though not with the levels of the cyclically-adjusted balances in FY2005/06, reflecting the differences between the Treasury’s and staff’s estimates of the output gap.

Table 5.

United Kingdom: Public Sector Budgetary Projections 1/

(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 growth projection. Official estimates are based on official growth projections.

Including depreciation.

End of fiscal year using centered-GDP as the denominator.

Staff estimates are based on staff projections of potential output. Official estimates are based on official projections of potential output.

Fiscal Balances and Public Debt 1/2/

(In percent of GDP)

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Sources: Pre-Budget Report 2005 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.

Based on centered GDP.

18. Treasury officials expected the overall deficit to narrow to about 1½ percent of GDP over the medium term. The further improvement in the cyclically-adjusted deficit relative to GDP by ¾ percentage point during FY2005/06—FY2010/11 reflects three main factors: fiscal drag; expenditure restraint starting in FY2008/09; and a recently-announced increase in the supplementary income tax rate on North Sea corporations. Specific plans to underpin the envisaged expenditure restraint are currently being developed as part of an overall review of government spending, the Comprehensive Spending Review (CSR), due to be completed in mid-2007. The Treasury expects the non-cyclically adjusted balance to improve by an additional ¾ percentage points of GDP. The underlying and unadjusted current balances would improve by similar amounts, as capital spending is projected to remain roughly constant as a share of GDP.

19. Staff welcomed both the intention to further reduce the overall deficit and the emphasis on spending restraint, which are in line with Fund advice. The desirability of early adjustment based on slowing the growth of current spending is underlined by staff analysis (Box 4). With nondiscretionary spending (Annually Managed Expenditure), such as social security benefits and interest payments, amounting to about 40 percent of total spending, the real growth of discretionary spending (Departmental Expenditure Limits) will need to fall to less than half of recent rates. Regarding the possible adverse effect of the announced increase in income taxes on North Sea corporations for incentives to invest in energy extraction, Treasury officials noted that—with higher energy prices—expected after tax rates of return on investment are still high (above 20 percent). Staff analysis suggests that corporate taxation becomes less distortionary as profit margins rise.

Fiscal Adjustment—Timing and Composition

Early fiscal adjustment focused on containing the growth of spending would have the most favorable impact on output in the medium term, according to staff estimates based on simulations using the IMF’s Global Fiscal Model calibrated to the U.K..1 In the baseline scenario (delayed consolidation), fiscal deficits are financed for five years by issuing debt, before taxes are eventually raised. Alternatively, early consolidation dampens aggregate demand in the short term but increases output in the long term because the government’s interest payments—and thus tax rates—are lower. Regarding the composition of adjustment, spending restraint has a more favorable effect on output than tax increases because of the adverse supply effects of higher taxes. In net present value terms, the gain is about 6 percent of one year’s GDP for early consolidation through spending restraint and about 3 percent through higher revenue. Corporate income taxation is less distortionary if profit margins are higher, because a larger share of the tax burden falls on rents rather than the return to capital.

1/ Selected Issues Paper, Options for Fiscal Consolidation in the U.K..

20. Staff projections suggest that the overall deficit will narrow to 2 percent of GDP by FY2010/11, somewhat less than projected by the Treasury but still adequate to stabilize debt. Given expected nominal GDP growth of about 5 percent over the medium term, an overall deficit of about 2 percent of GDP is sufficient to contain net debt at about 40 percent of GDP. Staff project the current balance to improve to about ¼ percent of GDP by FY2010/11. Given that the policy assumptions are the same, the main difference between staff’s and Treasury’s medium-term projections relates to the revenue gain from closing the output gap. In addition, staff projects a more gradual improvement in the cyclically-adjusted balances, especially in FY2006/07, when the main factors behind the increase in underlying revenue are the tax increase on North Sea corporations (amounting to 0.2 percentage points of GDP) and fiscal drag (amounting to 0.1 percentage points of GDP). By contrast, the Treasury expects a sharper increase in underlying revenue in FY2006/07, in line with the momentum of FY2005/06. Treasury officials envisage a much bigger increase in non-North Sea corporation tax revenue as a share of GDP.

uA01fig31

Average Cumulative Current Balance Since 1997

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig32

Net Debt

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

uA01fig33

Non-North Sea Corporation Tax

Citation: IMF Staff Country Reports 2006, 086; 10.5089/9781451814293.002.A001

21. Staff noted that the fiscal framework is at the forefront of international best practice. Although fiscal policy has recently produced large deficits and not avoided procyclical behavior, there appears to be widespread acceptance that the framework has constrained discretion. Moreover, the framework—which goes well beyond the rules per se—has particular strengths, including clarity, transparency, and reliance on independent audit. The National Audit Office (NAO), which is independent of the government and reports directly to Parliament, audits key assumptions and conventions underpinning the fiscal projections (Box 5). Staff welcomed the Treasury’s recent decision to ask the NAO to audit the redesignation of the start of the current economic cycle from 1999 to 1997.4 Treasury officials noted that the NAO had found the Treasury’s methodology to be reasonable. Staff suggested that, for the government to get due credit for its fiscal framework, transparency would be improved by extending the reach of NAO audit.

National Audit Office (NAO)

The NAO was established with a view to creating robust arrangements to ensure the independence of public auditors from the government. The 1983 National Audit Act gave the Comptroller and Auditor General express power to report to Parliament at his own discretion on the economy as well as on the efficiency and effectiveness of government spending. In 1997, the government invited the NAO to audit key assumptions and conventions underpinning the fiscal projections, so as to ensure that the forecasts are consistent with the principles of transparency and responsibility. This role was formalized under the Code for Fiscal Stability in 1998, which also requires the Treasury to publish any advice it receives. Since 2000, the NAO has audited key assumptions at the time of the Budget and Pre-Budget Report on a three-year rolling basis.

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22. Staff asked whether the precise dating of the cycle might be undermining the objective of the golden rule. Staff supported the rule as a means of protecting investment spending and guarding against procyclical fiscal policy, but noted two problems with its current application. First, different methodologies yield different interpretations of the economic cycle, so the attempt to be precise about dating the cycle inevitably leads to controversy.5 Second, meeting the rule could require procyclical policy toward the end of a cycle.6 Staff suggested that an exclusively forward-looking interpretation of the golden rule—for example, a rolling target of balance 3-years hence for the current budget—would reduce these drawbacks. However, to preserve credibility, a new interpretation of the golden rule should not be introduced until the current budget is back in balance. The authorities responded that precise dating provides a clear ex post test of whether the golden rule has been met, arguing that under previous governments fiscal rules had foundered because they lacked such a test.

E. Financial Stability

23. Increased macroeconomic stability and financial innovation are positive developments, but are also changing the landscape of risk. Low and stable inflation and less volatile economic growth have reduced uncertainty about future cash flows, but this may be leading some investors to be overly optimistic about policymakers’ ability to offset macroeconomic shocks. At the same time, rapid financial innovation, notably in derivative and securitization markets, has facilitated risk diversification, allowing banks in particular to transfer credit risk to a wide base of investors, and thus increased the capacity of the financial system to bear risk. However, the authorities and staff agreed that risk transfer markets have made the ultimate destination of these risks more opaque, complicated contract enforcement problems, and enabled the build-up of leverage. Together, macroeconomic stability and financial innovation have contributed to expectations of continued low asset price volatility and low risk premia, though some investors may be overly sanguine about the underlying risks of some financial products, particularly in the current low yield environment.

24. In this environment, the authorities are pursuing several policy strategies. First, they are raising awareness by publicizing risks to the outlook, to focus attention on common exposures. Second, they are continuously improving their ability to respond to shocks, incl