United Kingdom
2006 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for United Kingdom

This 2006 Article IV Consultation highlights that macroeconomic performance in the United Kingdom remains impressive. After softer growth in 2005, the acceleration in GDP in 2006 was broadly based. Business investment was boosted by high net rates of return; private consumption by robust employment growth, steady wage growth, and rising household wealth; and exports by the recovery in the euro area. Most indicators suggest little economic slack as of end-2006. The financial sector continues to thrive, and linkages with financial systems in other countries continue to grow.

Abstract

This 2006 Article IV Consultation highlights that macroeconomic performance in the United Kingdom remains impressive. After softer growth in 2005, the acceleration in GDP in 2006 was broadly based. Business investment was boosted by high net rates of return; private consumption by robust employment growth, steady wage growth, and rising household wealth; and exports by the recovery in the euro area. Most indicators suggest little economic slack as of end-2006. The financial sector continues to thrive, and linkages with financial systems in other countries continue to grow.

I. Introduction

1. Recent developments reflect a continuation of a decade-long record of strong and steady macroeconomic performance. During 1996–2005, the growth of real GDP per capita was higher and less volatile than in any other G7 country. Unemployment and inflation were low and stable, and the current account deficit was moderate.

uA01fig01

Growth of Real GDP Per Capita, 1996-2006

(in percent)

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

1/ Standard Deviation (inverted scale).

2. Recent and planned macroeconomic policies, in a broadly supportive international environment, are well-suited to sustaining these strengths (Box 1). Wide-ranging structural reforms over the past two-and–a-half decades have increased the economy’s openness and flexibility, paving the way for reaping important benefits from globalization. Macroeconomic policies have contributed to growth and stability, encouraging households and businesses to plan for the long term and positioning the economy well to respond to shocks.

Surveillance and Policies1

Fiscal policy: Fiscal adjustment in 2005 was in line with the Fund’s views on the need to narrow the fiscal deficit and stabilize net public debt. The authorities and the Fund share the view that the rules-based fiscal framework has constrained discretion and allowed automatic stabilizers to operate. Consistent with Fund recommendations, the authorities have broadened the scope of independent audit of the budget assumptions.

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 settlements systems.

Pension system: The government has proposed pension reform, supported by the Fund, that will help ensure both adequate saving for retirement and fiscal sustainability.

1 The latest Public Information Notice is available at http://www.imf.org/external/np/sec/pn/2006/pn0624.htm

3. While the economic outlook is favorable, a crystallization of risks could threaten macroeconomic stability, so managing shocks will remain a challenge. Given the economy’s openness, global shocks influence the United Kingdom quickly and strongly. Some shocks have had and continue to have positive effects, including the rapid growth of productivity in emerging Asia, immigration, and the increased demand for financial services. Other shocks, such as the global downturn of 2000–03 and the increase in oil prices during 2004–06, were managed with good policy responses. For example, the shallowness of the UK growth slowdown during last global downturn reflected in part the most aggressive fiscal expansion of any G7 country, alongside a reduction in interest rates and a sharp increase in house prices.

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Change in Output Gap

(2000-03)

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

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Change in Structural Fiscal Balance

(2000-03)

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

4. In light of the high convergence between the authorities’ and staff views on the outlook and policies, this report focuses on the capacity of macroeconomic policies to respond to shocks.1 Although openness and flexibility are important shock absorbers, the positioning of policies is also key. In this vein, the fiscal framework has constrained discretion, but there is a question whether over time margins for fiscal stabilizers under prudent rules should be increased. Regarding monetary policy, a question is whether globalization shocks could weaken the link between economic slack and inflation or distort perceptions of potential. The financial sector, despite its strong performance, could be affected by shocks in international financial markets, especially given London’s role as a global financial center. This report first covers recent developments and the outlook, then provides staff’s analysis of the positioning of macroeconomic and financial policies, before turning to the authorities’ views and the staff appraisal.

II. 2006—Balanced Recovery Pushing Close to Capacity Constraints

5. Domestic demand alongside strong exports drove a pick up in GDP growth during 2006 (Figure 1, Tables 1 and Tables 2). The mild downturn in 2005 reflected the United Kingdom’s advanced cyclical position, the abrupt deceleration of house prices, and the sharp increase in oil prices. The pick-up in 2006 was anticipated, though it came slightly more quickly than expected. Business investment was supported by high net rates of return, in part due to the low cost of capital. Residential investment was boosted by a surprisingly strong acceleration of house prices. The upturn in private consumption was based on robust employment growth, steady wage growth, and rising household wealth, including housing wealth. The recovery in the euro area boosted export growth.

Figure 1.
Figure 1.

United Kingdom: Economic Growth

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

Table 1.

United Kingdom: Selected Economic and Social Indicators

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Sources: National Statistics; HM Treasury; Bank of England; IFS; INS; World Development Indicators; and IMF staff estimates.

ILO unemployment; based on Labor Force Survey data.

The fiscal year begins in April. 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.

Table 2.

United Kingdom: Quarterly Growth Rates and Contribution to Growth

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Sources: Office for National Statistics; and staff estimates.

6. Most economic indicators suggest little economic slack as of end-2006. Staff’s production-function-based estimate suggests that the output gap at end-2006 was close to zero. In addition, measures of capacity utilization have risen over the past year and are now above their historical averages. The unemployment rate, however, increased through mid–2006. The dampening effect on labor demand from higher energy prices and the surge in new entrants to the labor force appear to have been key factors. Both should be temporary. Productivity growth rebounded in line with output growth, consistent with a decline in labor hoarding.

uA01fig04

Output Gap

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig05

Survey Estimates of Capacity Utilization

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

Sources: Bank of England; and British Chambers of Commerce.
uA01fig06

Unemployment Rate

(in percent)

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

7. Wage growth has been steady, but profit margins in the non-energy sector have fallen. Over the past year, the increases in both actual private sector earnings and pay settlements have been stable. The deceleration in unit wage costs has been mainly due to the procyclicality of productivity growth. However, in the non-energy sector, with subdued output price inflation, the share of profits in output declined from mid–2004 to mid–2006, reflecting sharp increases in contributions to company pension plans and input costs. As these factors wane, the profit share should rise.

uA01fig07

Wage Growth

(in percent)

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

1/ Private sector average earnings, excluding bonuses.2/ Economy-wide, based on earnings including bonuses.
uA01fig08

Profit Share of Non-oil Private Sector

(in percent of non-oil private sector final output)

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

Source: Bank of England.

8. In light of the pick up in GDP growth and concerns about second-round effects of cost pressures, the Bank of England (BOE) began raising the policy interest rate in mid-2006. Following a decade of low core inflation due in part to globalization and efficiency gains (Box 2), inflation rose above target in May 2006, reflecting primarily higher energy prices (pass-through to utilities prices continued through late 2006). But core inflation (ex-energy and food) increased too, as the decline in core goods prices subsided and services price inflation picked up. Owing to concerns about rising costs, The real policy rate has increased back to its 2004 level. Given projected nominal GDP growth of about 5½ percent over the medium term, a policy interest rate of 5¼ percent is broadly neutral.

Globalization, Efficiency Gains, and Inflation

Subdued core inflation in industrial countries over the past decade is often attributed to rapid growth in emerging Asia (which has dampened the prices of imported manufactured goods) or efficiency gains (notably in the distribution sector). In the United Kingdom, efficiency gains in the distribution sector reflect mergers and acquisitions, as well as the growth of “big box” style retailing (“Tescoization”).

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Impact of Asia Productivity Gains on U.K. Inflation

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig10

Relative Impact on U.K. Inflation

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

Staff analysis, using the Fund’s Global Economy Model, suggests that rapid growth in Asia has had a larger dampening effect on the relative price of goods in the United Kingdom than in the United States or the euro area, but that the impact on UK core inflation is much smaller than that of efficiency gains in the UK distribution sector.1 The Asia effect is bigger in the United Kingdom for two reasons. First, since imports from Asia constitute a larger share of UK absorption, the direct effect on goods prices is larger. Second, from Asia’s perspective, the required increase in the volume of imports from the UK needed to equilibrate the current account is smaller than that from the US or the euro area, so the depreciation of sterling against emerging Asia currencies is smaller than that of the US dollar or the euro.

1 Benjamin Hunt, “U.K. Inflation and Relative Prices over the Last Decade: How Important Was Globalization?” in United Kingdom—Selected Issues.
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Policy Interest Rate and Government Bond Yield

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig12

CPI Inflation

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

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Services Inflation and the Output Gap

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

1/ Lagged 4 quarters, in percent of potential GDP.
uA01fig14

Real Policy Interest Rate

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

9. House price growth increased during 2006, and house prices are likely overvalued. Following the stabilization of house prices in 2005, house price appreciation picked up again in 2006, reflecting in part the combination of a decline in 2-year bond yields and the growth of fixed-rate mortgages, which are priced off 2-year bond yields. As a result, the ratios of house prices to average earnings and rents, which were already at historical highs, increased further. However, estimates of house price overvaluation are subject to great uncertainty, not least because of the difficulty of incorporating supply constraints. Such constraints appear to have loosened somewhat in recent years, as the share of residential investment in GDP has grown substantially.

uA01fig15

House Price to Rent Ratio

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig16

Residential Investment

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

10. Although the current account deficit and the international investment position deteriorated in 2006, neither is a significant vulnerability. The current account deficit widened in 2006 to 3 percent of GDP, roughly the same as it was in 2000. Between 2000–06, a considerable increase in the trade deficit was matched by an increase in net investment income (Table 3). Over the past decade, the current account balance worsened, reflecting a gradual deterioration in the household and the public sector saving-investment imbalances only partially offset by an improvement in the corporate savings-investment imbalance. The decline in the net international investment position (IIP) in recent years is due primarily to sterling appreciation against the US dollar (Appendix II). Notwithstanding the negative IIP, net investment income is projected to remain in substantial surplus, as the United Kingdom earns more on its external assets (especially foreign direct investment) than it pays on its liabilities (mostly sterling-denominated debt).

Table 3.

United Kingdom: Balance of Payments

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Sources: Office of National Statistics (ONS) and staff projections.
uA01fig17

Current Account

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig18

Net Lending/Borrowing by Sector

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig19

Net International Investment Position

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

11. Despite the gradual increase in the current account deficit, competitiveness is broadly appropriate. The real effective exchange rate has been less volatile than those of other major currencies over the past five years. The UK share of exports of goods and services in G7 exports has been steady, with an increase in the services share offset by a decline in the goods share. Inward foreign direct investment (as a share of GDP) has risen in recent years to exceed the level recorded at the peak of the equity price boom in 2000. Some of the staff’s multilaterally-consistent measures of equilibrium exchange rates suggest that sterling is slightly overvalued, though well within the bounds of uncertainty surrounding the methodologies.2

uA01fig20

Real Effective Exchange Rate

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig21

U.K. Export Share

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

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Inward Foreign Direct Investment

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

III. Strong and Steady Outlook

12. In 2007–08, growth is projected to be broadly in line with potential, with inflation falling to target and the current account deficit stabilizing (Table 4). The increase in net immigration—especially from new EU member states—will boost growth potential (Box 3). At the same time, the growth of domestic demand should remain steady as positive influences (continued robust employment growth and steady wage growth) are broadly matched by the dampening effect of recent increases in the policy interest rate.3 Given the appreciation of the real effective exchange rate over the past year and a slight easing of growth in major export markets (primarily reflecting the slowdown in the United States), the current account deficit is expected to widen further in 2007 and then remain steady. With the appreciation of the exchange rate and the decline in energy prices, CPI inflation is projected to return to target by late–2007. In 2009 and beyond, there are no obvious reasons for the macroeconomic outlook to change.

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.

Public investment and business investment in 2005 and 2006 exclude the transfer of nuclear reactors.

Contribution to the growth of GDP.

These numbers exclude VAT-related fraudulent activity.

In percent of GDP.

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

Whole economy, per worker.

uA01fig23

Household Interest Payments and Policy Rate

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

The Macroeconomic Impact of Immigration

How is the surge in immigration to the United Kingdom from Central Europe following the accession of new EU members in May 2004 affecting potential output, the current account balance, and other key macroeconomic variables?1 Although the precise number of immigrants is uncertain, the labor force survey estimates that the number of accession country nationals increased by about 185,000 (about ½ percent of the labor force) in the two years since accession. The vast majority of these immigrants are less than 30 years old and virtually all are employed.

Staff analysis, using a dynamic overlapping generations model, indicates that the medium-and long-term (through 2050) macroeconomic effects of a long-lived immigration shock should be favorable.2 After about 10 years, the impact on real GDP per capita is positive, as the immigrants accumulate experience and become more productive. The current account balance deteriorates for about 20 years, reflecting both a lower saving rate (as young immigrants consume and remit more than the average worker) and a higher investment rate (to equip the new workers with capital).

uA01fig24

Real GDP

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig25

Current Account Balance and Savings

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig26

Investment and Capital Stock

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig27

Consumption

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

1/ Starting in 2007, workers from the newest members—Bulgaria and Romania—will be admitted in some sectors, subject to tight quantity restrictions.2/ Dora Iakova, “The Macroeconomic Effects of Immigration in the U.K.” in United Kingdom—Selected Issues.

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.

13. Prospects for the longer term are also good, particularly as population aging will not be as severe as elsewhere and the recent pension reform proposal lessens concerns about the adequacy of private saving for retirement. With a less generous state pension system than in other G7 countries, government projections show that—to keep net public debt below 40 percent of GDP—the required improvement in the primary balance as a share of GDP is only about ½ percentage point per decade starting in the 2030s. Staff analysis points to the large uncertainties surrounding these long-term projections, especially for health care spending.4 Uncertainties about the adequacy of saving for retirement will, however, be reduced by three key elements of the pension reform proposal: shifting the indexation of the flat-rate state pension from prices to average earnings (to reduce the spread of means-testing); introducing a national, defined-contribution scheme with automatic enrolment and low operating costs; and raising the state retirement age in line with rising life expectancy.5 The reform would address the existing disincentives to private saving for retirement and preserve fiscal sustainability, as the savings from the rise in the state retirement age would largely offset the cost of indexing pension payments to earnings.

14. Notwithstanding the strong and steady outlook, risks are not insignificant:

  • Immigration may expand the economy’s productive capacity more quickly than is currently envisaged. The large wage differentials between Western and Central Europe suggest that migratory flows may remain substantial for several years, though it is difficult to predict the precise allocation of these immigrants across countries in Western Europe.

  • In the short term, forward-looking indicators of housing market activity suggest that house price growth is likely to remain elevated. In light of estimates that house prices are already overvalued, this would increase the subsequent risk of an abrupt downward adjustment. The current strength of household balance sheets reflects in part high house prices.

  • External risks are low-probability but potentially high-impact, particularly as the global financial center could transmit shocks to the domestic economy. Higher global interest rates could trigger a reassessment of asset valuations, including UK house prices. Slower global growth would dampen external demand for UK goods and services. A disorderly adjustment of the US dollar could put upward pressure on sterling, leading to a widening of the UK current account deficit and a worsening of the IIP, ultimately producing considerable exchange rate volatility.

uA01fig28

Mortgage Approvals and House Prices

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

1/ Average of Halifax and Nationwide house price indices.

15. Such risks present a challenge for macroeconomic and financial sector policies. Policymakers face not only low-probability, high-impact risks, but also more immediate questions of how policies should respond to changes in the environment from immigration and globalization. The Bank of England faces the challenge of assessing how these influences affect inflation and how monetary policy should respond to them. Fiscal policy needs to ensure that both the fiscal rules and the underlying debt position permit appropriate countercyclical behavior. Financial sector policies need to keep supervision and crisis management tuned to changing risks.

IV. Challenges in Anchoring Inflation Expectations

16. With CPI inflation having been above target since May 2006, inflation expectations could become less well anchored. The longer headline inflation persists above target, the greater the risk of a shift toward higher inflation expectations. The BOE’s survey measure of the public’s inflation expectations is now at its highest level in several years.

uA01fig29

BOE Survey of Inflation Expectations 1/

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

1/ Over the next 12 months.

17. This heightens concerns that higher-than–target inflation could be embedded in upcoming pay deals. The inflation forecast assumes that private sector wage growth remains stable, reflecting in part continued slack in the labor market. However, with energy and other input prices now expected to be permanently higher than they were a couple years ago, a temporary slowing in real wage growth to rebuild margins of non-energy producing firms is inevitable. For this to happen without a secondary burst of inflation, nominal wage restraint in upcoming pay deals (many are concluded during the first quarter of the year) is essential. The recent interest rate increases send a strong signal on this score and further increases would be needed if wage restraint were not to continue.

18. Recent rapid broad money growth has raised concerns but is difficult to interpret. M4 growth increased sharply over the past year, driven largely by deposits held by nonbank financial companies (known as other financial corporations or OFCs). To the extent that these money balances are eventually used (for example, by pension funds) to purchase other assets, this build-up in liquidity could be associated with upward pressures on demand and subsequently inflation. However, these money balances could also partly reflect financial innovation. For example, pension funds and insurance companies are holding more deposits to finance derivative payments. Moreover, evidence suggests that the link between broad money growth and inflation in the United Kingdom in the short–to medium-term is weak.6 On balance, staff do not view recent broad money growth as a major concern, though careful monitoring is appropriate.

uA01fig30

M4 and Nominal GDP

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig31

M4 Holdings by Sector

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

19. Turning to global risks, a key challenge for the BOE is judging when the deflationary impact of rapid productivity growth in emerging Asia will wane. Looking back, subdued core inflation has been due in part to falling prices of imported manufactured goods and efficiency gains in the distribution sector. Looking forward, two risks stand out. First, the pace of productivity growth in Asia or the UK distribution sector may slow. Second, even if these underlying trends persist, their dampening effects on UK inflation will eventually diminish, because households learn about them and incorporate them into their expected wealth. This will tend to boost aggregate demand. Rising prices of non-energy imported goods suggest that the effect of the Asia productivity shock is already waning and that the level of the policy interest rate needed to secure the inflation target may be shifting up.

20. Another risk from globalization is that the influence of monetary policy on inflation diminishes. Increased trade makes goods prices in any given country less sensitive to domestic demand pressures, while increased cross-border labor mobility makes wages less sensitive to the domestic labor market. Both developments weaken the link between domestic economic slack and domestic inflation. One implication is that the BOE needs to worry less about temporary imbalances between demand and supply. Another, however, is that deviations of inflation from target are likely to become more persistent. Thus, if wage growth were to increase, then the BOE would need to keep monetary policy tight for longer to bring inflation back to target (Box 4).

uA01fig32

Flattening of the Phillips Curve

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

21. Altogether, with interest rates now within a broadly neutral range, monetary policy is well-positioned to respond in either direction to unexpected developments. If inflation expectations do not moderate or signs of wage pressures were to emerge, additional tightening would be desirable. In this event, interest rates may need to be held higher for some period. Conversely, if global growth were to slow more sharply than currently envisaged or the UK housing market were to weaken substantially, interest rate cuts should be considered. Moreover, any decision would need to be conditioned on new evidence of the effect of immigration on the potential output. But the scope for interest rate adjustments to adequately address large shocks appears ample.

Globalization and Monetary Policymaking

Globalization is widely seen as contributing to a flattening of the Phillips curve (the link between inflation and measures of economic slack) in the United Kingdom and other industrial countries over the past decade. Using a small macroeconomic model, staff analysis finds that a flatter Phillips curve has three main implications:1

  • First, macroeconomic volatility increases. With the weaker link between inflation and economic slack, higher output variability is needed to achieve a given level of inflation variability.

  • Second, a central bank that cares about inflation and (even a small amount) about deviations of output from potential should respond relatively less to deviations of inflation from target in deciding monetary policy stance. This is because the deviation of output from potential needed to bring inflation to target quickly is much higher when the Phillips curve is flatter.

  • Third, even though the central bank’s response to a given deviation of inflation from target is attenuated, interest rates would need to stay higher for longer after a positive shock to inflation, since deviations of inflation from target are more persistent. Conversely, the cumulative interest rate movement would be smaller after a demand shock.

uA01fig33

Impulse Responses to an Inflation Shock

(percentage point deviation from baseline)

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

1/ Dora Iakova, “Flattening of the Phillips Curve: Implications for Monetary Policy” in United Kingdom—Selected Issues.

V. Protecting Counter-Cyclicality in Fiscal Policy

22. A substantial fiscal expansion in 2001–04 led to a sharp deterioration in the fiscal balance and rising net public debt (Table 5). During this period, the government undertook a significant expansion in spending to increase public services. While this increase provided beneficial countercyclical stimulus during 2001–02, it continued in the stronger macroeconomic environment of 2003-04.

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.

uA01fig34

Net Public Debt 1/

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

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

23. A reversal of the deficit started in FY2005/06, but much remains to be done to return the fiscal position to one with ample space for fiscal stabilizers.7 In FY2005/06, the cyclically-adjusted overall balance relative to GDP improved by ½ percentage point, primarily due to windfall energy-price–related revenues and higher revenues from the booming financial sector. In FY2006/07, receipts and expenditures during the first nine months of the year point to some further improvement in the cyclically-adjusted overall deficit, reflecting buoyant personal and corporation income tax revenue (in turn due to the continued strength of the financial sector) and the higher tax rate on North Sea firms.

uA01fig35

Overall Balance

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig36

Current Balance

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

Fiscal Balances and Public Debt

(In percent of GDP)

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Sources: December 2006 Pre-Budget Report, and staff projections.

24. The authorities plan further adjustment over the medium term so as to return the current balance to surplus, relying primarily on spending restraint to do so. The December 2006 Pre-Budget Report presented a plan to lower the ratio of current spending to GDP by ¾ percentage points by FY2011/12. Capital spending as a share of GDP is expected to remain stable, in line with the OECD recommendation to redress decades of under-investment in public, especially transport, infrastructure. Appropriately, the Pre-Budget Report shifted away from previous plans to rely on higher revenue for the needed adjustment. The tax-to-GDP ratio is back to about its level in the second half of the 1980s, reflecting a combination of buoyancy and measures. After a small further rise in FY2007/08, the ratio is projected to remain roughly stable over the medium term, as fiscal drag is offset by a modest decline in the VAT base.

uA01fig37

Tax to GDP Ratio

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

25. Recent actions have strengthened the credibility of the commitment to spending restraint, but the Comprehensive Spending Review (due by mid–2007) will be the critical test. Key actions have been settlements with selected ministries (covering about 10 percent of discretionary spending) for 2008–10—with the Home Office (one of the largest ministries) for no real growth, with some smaller ministries (including the Department for Work and Pensions, HM Revenue and Customs, and the Treasury itself) for declines of 5 percent per year in real terms. Looking ahead, the objective is to achieve savings of at least 3 percent per year across central and local government, with administrative budgets across ministries reduced by at least 5 percent in real terms per year. While wage bargaining with public sector employees is conducted on a ministry-by–ministry basis, the Treasury has responsibility for approving government submissions to the pay review bodies. In 2006, the average pay increase in the public sector was 2½ percent, the lowest in a decade. The plan is to ensure that wage increases are affordable and consistent with the 2 percent inflation target over the medium term.

26. Once the adjustments in the Comprehensive Spending Review are in place, fiscal policy should ensure that net public debt remains below 40 percent of GDP, a limit that has served the economy well.8 On staff projections, net public debt will rise to just below 40 percent of GDP in the medium term. Countercyclical fiscal policy in the event of an adverse shock would then push net public debt over 40 percent of GDP. For example, staff analysis suggests that a sharp drop in house prices could lead to a slowdown in economic growth that would increase net public debt relative to GDP by about 3 percentage points.9 This would be consistent with holding debt below 40 percent of GDP “over the cycle.” However, staff would favor keeping the deficit at 1½ percent of GDP, which would gradually reduce the debt ratio, creating sufficient room for automatic stabilizers to work while maintaining debt below 40 percent of GDP “at all times.” The “at all times” formulation would provide a clearer measure of fiscal performance.

27. More generally, the fiscal framework has broadly contributed to stability. In particular, the fiscal rules—the debt rule and the golden rule (which requires current balance or better over the cycle)—have helped to constrain discretion and protect investment. Nevertheless, the definition of the golden rule as applying “over the cycle” has two widely-discussed drawbacks: the uncertainty surrounding the dating of the cycle and the risk of procyclicality in the event of asymmetric cycles. Possibilities for redressing them while preserving constraint on discretion exist, but it is not clear whether the cost of changing the rule outweighs the benefit.10 Separately, the credibility of the fiscal framework would be served by increasing the role of the National Audit Office in auditing certain assumptions underlying the fiscal projections. Since 1997, the government has invited the NAO, which is independent of the government and reports directly to Parliament, to audit some general macroeconomic assumptions and some specific assumptions (such as the effective VAT rate), so as to enhance the transparency of the Budget forecast. Broader NAO audit of key fiscal assumptions would further enhance fiscal transparency.

VI. Financial Stability: Risk of Global Shocks

28. The financial sector is thriving. Net exports of financial services have risen steadily over the past decade and increased sharply in recent years. Ratings agencies rank the highly profitable UK banking system as one of the strongest in the world. Robust economic growth, a benign interest rate environment, and a buoyant housing market have supported mortgage credit quality, though high-risk mortgage lending and bad debts on unsecured personal lending are increasing.11 High net rates of return have underpinned strong corporate credit quality and low levels of insolvencies. The health of the banking system reflects improved risk management, geographical diversification, and growth of new business activities. In particular, financial innovation has allowed banks to transfer some of the risk that they traditionally held on their own balance sheets. In turn, the ongoing shift from negotiated, bilateral banking finance to arms-length finance through asset markets has facilitated consumption smoothing (September 2006 WEO). Bank regulation and supervision have responded well to these developments. At the same time, the life insurance industry has returned to a more stable outlook, following several years of weakness. The introduction of a risk-based approach to determining capital adequacy has helped to increase awareness by insurers of the risks associated with the products they offer.

uA01fig38

Net Exports: Financial Services

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

uA01fig39

Banking System Quality Indicator

Citation: IMF Staff Country Reports 2007, 091; 10.5089/9781451814323.002.A001

Source: Fitch Ratings.

29. Linkages between the UK financial system and financial systems in other countries are growing. Specifically, linkages between the main UK and non-UK banks are strong and getting stronger. For example, in the London interbank market, the main UK banks’ exposures to the main foreign-owned banks amount to almost two-thirds of Tier 1 capital. Banks’ activities have also become increasingly intertwined with other parts of the financial sector and the broader economy. These growing linkages are both a strength and a vulnerability. They allow the impact of bad shocks to be more broadly dispersed (risk transfer) and thus more easily absorbed by individual institutions and the system as a whole. However, they also potentially allow the impact to be spread around the global financial system more widely and rapidly (Box 5).

30. Given these growing cross-country linkages, global risks are particularly important to the UK financial system, more for their potential severity than for their likelihood of being realized. If global interest rates rise, unusually low risk premia reverse, or major currencies move sharply, credit and market risks in the UK financial system could be realized. Extended balance sheets in the domestic nonfinancial sector are a vulnerability. Leverage, especially among commercial property companies and arising from leveraged buyouts, has grown rapidly.12 Household debt has also increased rapidly, mostly reflecting mortgage lending.13 Financial institutions’ own balance sheets also contain vulnerabilities. Exposures to risky and potentially illiquid instruments are rising, including structured credit products, emerging market assets, commodities, and commercial property. At the same time, reliance on wholesale funding is increasing, as reflected in the gap between customer lending and customer funding through deposits. This raises liquidity risks, as wholesale funding may be more difficult and costly to roll over during times of heightened stress.

Linkages Between Major International Banks

Staff analysis of extreme changes (“exceedances”) in distance-to-default measures in a group of major internationally-active banks yields two key results.1 First, the transmission of shocks appears to be more important among UK banks than between UK and non-UK banks. Second, over the past few years, the transmission of shocks between UK and non-UK banks has been rising. These results suggest that, while the national focus of financial supervisory authorities has been appropriate until now, improving international cooperation in financial crisis prevention and management is becoming more important.

Significant Coexceedances, 2000-2006

(in percent of total bank transmission channels)

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Source: IMF staff calculations.