Statement by Tom Scholar, 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.

My authorities are most grateful to staff for their work and will take careful note of their comments. There is a broad measure of agreement between staff and the authorities on most aspects of economic policy.

Economic prospects

Growth was below trend in 2005 at 1.8 percent, in the face of rising oil prices, weak demand in the euro area and the necessary slowing of the housing market and consumer spending. Nevertheless the UK was among the fastest growing European economies and continues to enjoy an unprecedented period of economic stability, with 54 consecutive quarters of growth, the longest unbroken expansion on record. The economic fundamentals remain sound: CPI inflation at 1.9 percent, short term interest rates at 4.5 percent, and employment at record levels of 75 percent. Growth is forecast (in the 2005 Pre-Budget Report) to increase to 2 to 2½ percent in 2006, and 2 ¾ to 3 ¼ percent in 2007, with inflation at or close to target. As staff note, there are risks: my authorities remain vigilant to these and agree with staff on the need for cautious macroeconomic polices, to which they are fully committed.

Monetary and fiscal policy

My authorities will continue to set policy on the basis of the policy framework established in 1997, and based on the principles of transparency, responsibility and accountability:

  • Fiscal policy set according to two fiscal rules:

    • the golden rule—over the cycle, the Government will borrow only to invest;

    • the sustainable investment rule—over the cycle, public sector net debt will be held at a stable and prudent level, defined as 40 percent or less;

  • Monetary policy set by the Bank of England’s Monetary Policy Committee to meet a symmetric inflation target.

My authorities agree with staff that the fiscal and monetary policy frameworks have served the UK well, anchoring expectations and delivering long-term stability.

Fiscal policy will, as usual, be set in the Budget. The latest official projections show a gradual reduction in the deficit to 1½ percent of GDP, with an average annual surplus on the current budget over the cycle, and net debt stabilising at 38 percent of GDP. My authorities are therefore meeting the fiscal rules.

Staff project a slightly higher medium-term deficit (2 percent), reflecting a different view of the output gap. My authorities believe that recent average earnings and labour market data point to considerable spare capacity in the economy. On prospects for the public finances, they expect the recent strength in monthly receipts to be sustained through 2006/07, and corporation tax to return to its long-term average. In any case they view the difference of view expressed by staff as modest, and well within the normal margins of error on medium-term fiscal projections.

Staff recognise that the fiscal rules have constrained discretion, as intended, and that they provide a means of protecting investment spending and guarding against pro-cyclical fiscal policy. But they suggest replacing a rule defined over the cycle (and which allows the automatic stabilizers to operate) with one requiring the current budget to be in balance three years ahead. My authorities believe this could introduce a risk of pro-cyclicality, given the typical pattern of economic cycles, and recall the unsuccessful experience with such a rule during the 1980s.

Staff suggest extending the scope of NAO audit. My authorities keep this constantly under review, and last year extended it to include the dating of the economic cycle (where, as staff note, the NAO endorsed the Treasury methodology as reasonable and concluded that the change would not reduce the extent of caution in the fiscal projections). There is also extensive external scrutiny of the government’s assessment of the output gap and the cyclical position of the economy.

On pensions, my authorities believe that the UK system is better placed than most to confront future demographic challenges. Nevertheless there are issues to be addressed, and the Pensions Commission’s report and the Treasury’s Long Term Public Finances Report provide useful analytical material for doing so. My authorities will provide their response to the Pensions Commission’s proposals in the coming months.

My authorities welcome the FSAP Follow-Up Report in the Selected Issues papers. This is well-focused, concentrating on what the UK authorities have been doing to implement the recommendations in the 2002 FSAP, and providing an assessment of current risks to the UK financial sector outlook. As a general policy matter it will be interesting to see whether this new approach will strengthen follow-up on FSAP findings in Article IV reports across the membership.

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
Author: International Monetary Fund