United Kingdom: Staff Report for the 2008 Article IV Consultation

This 2008 Article IV Consultation highlights that the United Kingdom’s economic growth was above trend in 2006 and 2007. In terms of expenditure, the expansion was largely driven by private consumption, on the heels of strong employment, steady real wage and living standards growth, and a surge in immigration. So far in 2008, evidence points to a sharp slowing in activity alongside high inflation. Executive Directors have welcomed the commitment made in the 2008 budget to tighten fiscal policy in the coming two years.

Abstract

This 2008 Article IV Consultation highlights that the United Kingdom’s economic growth was above trend in 2006 and 2007. In terms of expenditure, the expansion was largely driven by private consumption, on the heels of strong employment, steady real wage and living standards growth, and a surge in immigration. So far in 2008, evidence points to a sharp slowing in activity alongside high inflation. Executive Directors have welcomed the commitment made in the 2008 budget to tighten fiscal policy in the coming two years.

I. Staff Appraisal and Summary

The United Kingdom faces several challenges to continued strong economic performance

1. For over a decade, the United Kingdom has sustained low inflation and rapid economic growth—an exceptional achievement. This is the fruit of strong policies and policy frameworks. These now face new tests from the ongoing global shocks to financial markets and energy and commodity prices.

2. Challenges were evident, however, even before recent global shocks (¶16–¶24). Imbalances had emerged in recent years—inflation, overheating in housing markets, low domestic saving rates, high current account deficits, and sustained declines in the international investment position. The monetary tightening cycle from mid–2006 responded to the immediate inflation risks and began to cool the housing market. But medium–term inflation expectations—which had been rising for some time—remained elevated, and the real effective appreciation of sterling compounded underlying external imbalances. Alongside, although net public debt remains low, fiscal policy was not tight enough to maintain headroom under the sustainable investment and golden rules.

A moderate slowdown is underway, and will help

3. Growth is set to slow below trend during 2008 and 2009. This will help attenuate inflationary and external pressures in the near term, albeit at the expense of further erosion of headroom relative to the fiscal rules. In the staff’s central projection, the slowdown this year will be followed by a gradual rebound that gathers pace during 2009. Specifically, year–on–year growth is projected to decline to 1¼ percent in the fourth quarter of 2008 before recovering to 2¼ percent a year later. Shocks to commodity prices and sterling depreciation are set to keep CPI inflation above target well into 2009, even in the absence of second–round nominal wage pressure. But with improved competitiveness and slower growth, the current account deficit is expected to narrow in the near term (see ¶25–¶38). These forecasts reflect the underlying resilience of the economy, and the view that risks of a pronounced credit squeeze are becoming less threatening following various actions, including introduction of the Special Liquidity Scheme (SLS) and capital raising initiatives by banks.

But risks of a sharper downturn remain, and imbalances may reemerge

4. Uncertainty focuses on the impact of ongoing dislocation in global financial markets, associated spillovers across markets, the ongoing correction in the U.K. housing market, terms of trade shocks, and possible adverse feedback loops (see ¶39–¶40). And adjustments in the policy mix to support external relative to domestic demand over the medium term would provide insurance against imbalances reemerging when output eventually returns to trend. The recent global shocks have increased the importance of this shift.

Sustained balanced growth requires a three–pronged strategy

5. Given the outlook and risks, a package of complimentary policies is needed: an underlying fiscal stance that supports rebalancing over the medium term, a monetary stance that remains focused on the inflation target, and actions to forestall further financial sector shocks.

First, an appropriate fiscal stance for 2009 and beyond

6. Budget consolidation would help rebalance demand away from domestic in favor of external (see ¶41–¶42). Absent a marked worsening in near–term growth prospects, the commitment made in the 2008 budget to tighten fiscal policy by ½ percentage point of GDP in cyclically–adjusted terms in both 2009 and 2010 should not waver1. In addition, any slippage from the neutral fiscal stance for 2008 that was anticipated in the budget should also be corrected. And if the medium–term outlook for the current account deteriorates, additional structural fiscal consolidation may be needed for 2009 and beyond. Early announcement of any such revisions to budget commitments would allow their prompt reflection in monetary policy decisions.

Second, monetary policy should aim to keep second–round effects in check

7. Adjustments to the monetary stance must weigh the upside risks to inflation against the potential disinflationary effect from downside risks to output. Given the outlook for these factors, the current halt in monetary policy easing is appropriate. Risks on both sides appear balanced. Unexpected output weakness or wage deceleration could justify a further reduction in the bank rate, and a tighter fiscal policy would provide room. But signs that wage restraint or inflation expectations are slipping may warrant a rate increase to send a strong signal.

8. In this connection, continued moderation in nominal earnings growth will be essential. If secured in the face of large relative price changes, monetary easing and associated sterling depreciation may reduce risks to output, the external balance, and employment without compromising the nominal anchor. If not, monetary flexibility to address these concerns will be diminished (see ¶43–¶45). The risks to nominal wages appear balanced. So far, nominal remuneration has held steady, encouraged by the flexibility of labor market institutions and public sector pay restraint. But key wage settlements remain outstanding, and tolerance for ongoing low real earnings growth is uncertain with continued tight labor markets.

Third, stabilizing financial markets

9. Efforts to stabilize financial markets will not only reduce lagged effects on credit flows from past strains, but will also reduce remaining risks and support more efficient pricing of risk in future. The steps outlined in the Bank of England’s Financial Stability Report form a good basis for action in this regard. The SLS addresses liquidity tail risks while guarding against moral hazard, and has already contributed to an easing in money market pressure. In difficult market conditions, banks can further boost confidence in their resilience through information disclosure and raising capital, as some are already doing (see ¶46–¶47).

Alongside, reforms to policy frameworks are needed

10. The U.K.’s policy frameworks have been the foundation of strong policy macroeconomic performance over the past decade, but these frameworks are being tested by current economic conditions. Selected reforms would help maintain confidence in medium– term prospects.

The inflation targeting regime remains appropriate as is

11. The inflation targeting regime faces its most difficult test to date, but should remain unaltered. Adjusting the inflation target, its definition, or the remit of the Bank of England to include output objectives, as suggested by some outside commentators, would be a serious mistake. Such steps would risk unanchoring nominal wage settlements without changing the fundamental challenges facing the economy (see ¶48).

The fiscal sustainable investment rule also remains appropriate

12. Margin for error under the fiscal rules has been all but eliminated, and a breach of the debt ceiling is likely as early as 2009, but key elements of the fiscal framework should be retained. Specifically, the commitment to maintain net public debt below 40 percent of GDP in each and every year remains appropriate. It constrains fiscal discretion within boundaries set by long–term considerations and also underpins the credibility of the inflation targeting regime. If public debt—net of stock adjustments—were to breach 40 percent of GDP, concrete plans to bring it back under the ceiling on a sustained basis should be announced promptly. Further, to improve the operation of the framework and support automatic stabilizers over the medium term, it will be important to develop procedures to manage headroom under the ceiling (see ¶49–¶53).

But the fiscal framework could be strengthened

13. In particular, building on the success of the recent Comprehensive Spending Review in slowing the pace of expenditure growth, consideration should be given to reversing the relative status of the golden rule and the medium–term spending limits. An expenditure rule would be transparent, reduce risk of expenditure drift, and strengthen fiscal resistance to unanticipated inflation (see ¶54–¶55).

And significant reforms to the financial stability framework are needed

14. The framework of tripartite co–operation among the Bank of England, Financial Services Authority (FSA) and Treasury remains appropriate. However, in light of the lessons learned during the financial market turmoil since mid–2007, the authorities have identified areas in which the tripartite and broader financial stability framework can be strengthened, including crisis management.

15. In taking these matters forward, focus is required in a number of areas to strengthen market and supervisory discipline on financial institutions (see ¶56–¶66). These include improved disclosure by financial institutions, and further elaboration of the regime of remedial measures to be applied by supervisors against weak institutions crossing various thresholds. Alongside, the aim of early intervention in distressed institutions under the proposed special resolution regime is appropriate and should be supported by specifying the criteria for its application. Although discretion will remain essential, the presumption that the regime would be triggered when the criteria are met strikes an appropriate balance between regulatory forbearance and unnecessary actions. And finally, even with the steps outlined above, financial stability will require strengthening the capacity of all implementing institutions, including better coordination within the tripartite arrangements and provision of a formal legal basis for the Bank of England’s role in financial stability.

It is proposed to hold the next Article IV consultation on the regular 12–month cycle.

II. The context—Imbalances and Policy Responses 2005–07

The origins of the large external deficits lie in buoyant domestic demand, with falling domestic savings accompanying rising investment ratios

16. After a mild slowdown in 2005, activity rose 3 percent a year in 2006 and 2007 (Table 1 and Figure 1).

  • Consumer spending was supported by robust labor market conditions—strong employment, steady real wage growth, and a surge in immigrant labor from EU accession countries after 2004 (Figure 2). Compressed global credit market spreads, loosening credit conditions, soaring household debt, and the decade–long housing boom provided additional fuel (Figure 3). In this context, household savings rates declined to 3 ½ percent of disposable income in 2007 from some 10 percent a decade earlier.

  • The low cost of capital, high corporate profitability, and capital spending to match the increased labor supply boosted investment, while residential investment responded to the strong housing market.

  • Alongside, the fiscal deficit remained high, especially for the peak of the cycle, and headroom under the fiscal rules was eroded.

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.

Figure 1.
Figure 1.

Real Developments, 2004‐07

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

Figure 2.
Figure 2.

Labor Market Developments, 2004‐07

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

Figure 3.
Figure 3.

Credit Developments, 2004–08

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

1/ Difference between rate on loans secured on dwellings, new advances on floating rate to households and rate on time deposits redeemable at notice from households.
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Household Debt and Net Housing Equity

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

uA02fig02

Household Savings

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

With reduced slack in the economy, inflation rose, a monetary tightening cycle began, and large current account deficits emerged

17. The bank rate rose five times from mid–2006 to mid–2007 by a cumulative 125 basis points to 5¾ percent, and sterling appreciated (Figure 4). In this context, the housing market began to cool, with turnover dropping from early 2007.

Figure 4.
Figure 4.

Monetary Policy and Inflation

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

18. Nonetheless, increased commodity and core (and notably services) prices pushed the CPI up, breaching 3 percent in March 2007—requiring the first explanatory letter from the Governor to the Chancellor under the U.K.’s inflation targeting setup.

19. In 2006–07, notwithstanding favorable export market growth, the balance of trade deteriorated, with the services balance not quite offsetting this (Table 2, Text Table 1). This deterioration was compounded by a sharp fall in the income balance following earlier sizeable FDI inflows. The widening current account deficit was accompanied by an appreciation of the CPI–based real effective exchange rate of almost 10 percent from 2006 through mid–2007 (Text Box 1. and Figure 5).

Table 2.

United Kingdom: Balance of Payments

(Percent of GDP)

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

External Balances

(Percent of GDP)

Data revisions in 2007 showed a significantly weaker net income position than earlier estimated. In particular, with earlier data unrevised, the income balance for 2006 was lowered by some 0.8 percentage points of GDP, indicating a significant deterioration in the external deficit from 2005. The income balance for the first half of 2007 was lowered by considerably more.

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Exchange Rate Assessment and Sustainability

In recent years, sterling appreciated significantly beyond norms in real terms (Text Figure 1). Alongside, the external current account balance and the net IIP position have both deteriorated (see Annex 1). Only half of the weakening in the current account deficit since 2003 reflects increased domestic fixed investment. And reflecting the external deficit and valuation changes, the IIP declined from a deficit of 4 percent of GDP in 2003 to a deficit of 25 percent of GDP in 2007 (Table 2, and Table 4). Staff econometric projections suggest that the IIP will remain on a deteriorating path. Since August 2007, the real effective exchange rate has depreciated by more than 10 percent, reflecting not only cuts in the bank rate (¶17) but likely also a reassessment of U.K. risk and views about the sustainable real value of sterling in the wake of global financial turmoil.

CGER–Sterling Overvaluation

(in percent)

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Quantification of the degree of overvaluation is complicated by uncertainties over the prospects for net income following the recent large data revisions. If the deterioration in the net income position is assumed to be temporary, as seems likely, the staff’s assessment—supported by evidence from the suite of CGER methodologies—is that sterling has moved closer to its equilibrium real value following its recent depreciation, but that it remains somewhat on the strong side.1/

Given open access to international capital markets, policy and data transparency, and the flexible exchange rate regime, risks of a destabilizing depreciation are low.

Text Figure 1.
Text Figure 1.

U.K. Real Effective Exchange Rate

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

1/ For details of CGER methodologies, see Exchange Rate Assessments: CGER Methodologies, IMF Occasional Paper 261, 2008.
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.

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.

In percent of potential GDP.

Table 4.

United Kingdom: Net Investment Position 1/

(Percent of GDP)

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Source: Office on National Statistics.
Figure 5.
Figure 5.

Competitiveness, 1999‐2008

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

20. By the eve of the financial market turmoil from August 2007, apart from the housing market, the broader slowdown that the Bank of England had sought to stem inflation had yet to occur. And external trends underscored the need for that slowdown to be accompanied by a rebalancing—with net external demand replacing domestic demand.

The context for the necessary macroeconomic adjustments became more difficult after August 2007

21. The U.K. was hit by two new shocks: the disruptions to global financial markets from August 2007 onwards, and sharp increases in food and fuel prices that started last year but intensified in recent months. These shocks raised uncertainties about export market and output growth prospects, disrupted money markets, compounded the ongoing correction in the domestic housing market, and increased inflation risks on both sides.

22. Policy faces several new challenges in this context. On the monetary side, the determination of the appropriate stance became more complicated, and the transmission mechanism became subject to repeated shocks as the financial market turmoil played out. On the fiscal side, it became increasingly difficult to reconcile full use of the automatic stabilizers with adherence to the fiscal rules. And on the financial stability side, the run on Northern Rock highlighted weaknesses in the framework, including the maintenance of adequate capital, bank resolution procedures and deposit insurance (see Annex 2).

That said, the turmoil may have temporarily lowered the external current account deficit and sterling overvaluation, with modest effects on output so far

23. Partly in anticipation of output weakness and its associated disinflationary impact, bank rate reductions were advanced. They have been lowered by 75bp in three steps and, until recently, markets were pricing in further rate cuts through 2008. In addition, despite continued dividend payments by U.K. banks in the fourth quarter of 2007, outflows from foreign–owned banks on the current account declined as the value of derivative positions was marked down in the wake of global credit tensions. This strengthened the current account deficit—which fell from 5 ½ percent of GDP in the third quarter to 2½ percent in the fourth—taking the annual deficit to 4¼ percent of GDP in 2007.

24. So far in 2008, activity—especially consumption—has surprised on the upside. In particular, preliminary national accounts data show that personal consumption strengthened in the first quarter, even as the housing market cooled and global demand began to soften. In addition, the labor market remains tight, with unemployment having edged up only slightly to 5.3 percent primarily because of fast labor supply growth. Nevertheless, wage and non-food non–fuel consumer prices remained subdued, with the rise in CPI inflation from 2.1 percent in December to 3.3 percent in May accounted for by large increases in the prices of food and energy rather than excess demand. While tax collections are below budget projections for the year through May, these data are highly volatile and it is too early to identify clear patterns.

III. Near–term Outlook and Risks

A. Factors Affecting the Outlook

Prospects for economic activity in the U.K. have dimmed

25. Notwithstanding developments early in 2008, the slowdown now forecast for the U.S. and the euro area in 2008–09, and ongoing strains in domestic credit markets, will all impose a toll on the U.K.. The severity of the impact depends significantly on the credibility of the inflation anchor, and hence the scope to offset weakening activity with monetary policy action consistent with the inflation target. Signs now are that—although the period of financial sector turmoil is not over—the overall impact of developments in banking markets may be less cause for concern than earlier thought. But even so, long–term trend growth may be somewhat lowered by the repricing of credit risk now underway.

Inflationary pressures have risen

26. Headline CPI, PPI, import, and input prices all signal pressures (Figure 4.). Indeed, with the PPI rising at much higher rates than the CPI, there is likely pent–up inflationary pressure in compressed manufacturing and retail margins that has yet to work through. In this light, the food and fuel price shocks and prospective domestic energy price adjustments all set the stage for a series of elevated CPI outturns—and associated need for several explanatory letters from the Governor to the Chancellor. This prospect remains even if global energy prices remain roughly unchanged from where they now are. The associated risks are underscored by direct surveys of household inflation expectations and evidence from indexed vis–à–vis non–indexed gilt spreads.

uA02fig03
uA02fig04

Inflation Expectations

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

1/ Spread between nominal and RPI–indexed 10–year sovereign bonds.

Mortgage credit has slowed, and involuntary lending may be obscuring a broader slowdown

27. Since August 2007, survey evidence of lenders’ quarter–ahead intentions have indicated that tighter credit standards were in prospect, suggesting a restriction in credit growth (see Annex 3). Loan–to–value ratios have fallen and the number of mortgage products has declined, together with a sharp increase in quoted mortgage rates for new borrowers in recent months. Accordingly, the seasonally–adjusted quarterly growth of secured net lending—four–fifths of the stock of lending to households—has dropped from an annualized average of 10 percent in the second quarter of 2007 to 6½ percent in May 2008.

28. Annualized growth of unsecured lending (including credit cards) flows has risen (from 6 to 8 percent) from the second quarter of 2007 to May 2008. Lending to private non-financial corporations has slowed, but various shocks to the series complicate interpretation. In both cases, the current pace of lending may reflect agreements predating the ongoing financial sector strains—on credit cards and credit lines for households and firms respectively. Anecdotal evidence suggests that new voluntary credit extension has slowed.

uA02fig05

Tighter Credit Conditions Ahead

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

Source: Bank of England and AllianceBernstein.
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Gross Mortgage Lending

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

Official liquidity support and capital raising efforts by banks have helped, but market strains remain

29. As part of efforts to support orderly functioning of money markets, the Bank of England announced a Special Liquidity Scheme swapping T–bills for assets including mortgage–backed securities. Despite the potential scale of the scheme—an initial take up of around US$100 billion was expected—the swap structure, including haircuts, ensures that credit risk remain with banks, while the fees and restriction to legacy assets on banks’ balance sheets at end–07 guard against moral hazard. The scheme represents a further extension of adjustments to the Bank of England’s money market operations, which since August 2007 have extended collateral, and amounts offered at auctions of 3–month maturity. A particular feature of the SLS is non–transparency—usage will not be announced until after closure of the drawdown window (at least six months)—aimed to overcome the “stigma” impeding use of other liquidity facilities. The aim was to buttress the liquidity of, and so confidence in, the banking system. Market commentators suggest this has been instrumental in reducing money market spreads. Nevertheless, as in euro and U.S. dollar markets, sterling spreads remain high.

30. Continued money market strains partly reflect ongoing concerns with counterparty risk, notably regarding adequacy of banks’ capital. Following subprime–related writedowns by the five big banks of £4.4 billion so far, staff estimates suggest that further writedowns of about £6 billion are to come (Annex 3). These would lower the total (Basel I) capital ratio of the five largest banks from 12.1 percent at end–2007 to 11.8 percent, with potential losses on other bank assets, including those on the weak domestic commercial property market, compounding these effects. Within these aggregates, mortgage lenders funded by residential mortgage–backed security (RMBS) issuance are under particular strain and share price valuations of two of the large global banks are being marked down heavily due to low levels of capital amidst the prospect for further writedowns and continued market turbulence.

31. In response, various initiatives are under way to raise capital. Four large banks have announced such plans since April. Widening spreads between bank deposit and lending rates have encouraged equity issue, particularly for largely deposit–funded institutions, but difficulties have still been encountered. In particular, underwriters may have to take up some of the stock, and if so, prospects for subsequent equity issues may be impaired (Figure 6).

Figure 6.
Figure 6.

Recent Financial Market Developments

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

32. Furthermore, even when credit supply conditions improve, risk premia in financial markets are likely to remain elevated compared to the unsustainably low levels prevailing prior to the August 2007 crisis.

House prices are falling rapidly, with further declines likely

33. After turnover began to fall from early 2007, nominal house prices on some measures have fallen some 8 percent since their autumn 2007 peak. With credit constraints and stretched affordability, further falls are likely. In particular, U.K. households typically maintain a relatively constant ratio of cash outflows of principal and interest on mortgages as a share of their monthly incomes. As this ratio has been elevated in recent years, it may be expected to revert to mean. Simulations for this process, based on staff assumptions on mortgage interest rates and household income growth, indicate that the “normal” cash flow burden can be retained with moderate nominal house price declines (induced by contracting demand) over a time frame typical of past corrections (Text Table 2). The results appear relatively robust to alternative macro assumptions, but are more sensitive to the assumed pace of correction, which could be faster than in the past or could overshoot previous norms. The central scenario assumes a cumulative decline in house prices of about 15 percent over two years rather than a precipitous correction. Some market indicators—including forward contracts on house price indices—suggest a cumulative fall of 20–25 percent by 2011

Text Table 2.

Affordability Adjustment

(e.o.p.; in percent)

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U.K.: House Price Appreciation

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

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U.K.: Property Transactions

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

The impact of housing corrections on activity may depend on developments in the broader economy

34. The impact of such house price declines on growth is expected to be contained, as long as other aspects of the U.K. economic environment remain broadly unchanged. This assessment reflects staff work on the direct links between house prices and consumption—finding a modest link, but one greater than other researchers have suggested.2 In addition, there is range of market analysts’ views concerning the effect of house price declines on banks’ capital, with some judging resilience to be considerable and others noting that housing market developments could lead to further negative rating actions for U.K. banks. The substantial cushion of equity in housing built up over the past housing boom, and—relative to the early 1990s—the low share of outstanding mortgages contracted at the crest of the market are reassuring. But if house price declines are accompanied by a deterioration in the labor market or a significant rise in mortgage rates—due to the bank rate, rising spreads, or as teaser rates expire—there would be a significant effect on mortgage delinquencies, feeding back into impaired bank capital and new credit extension.3

uA02fig09

Real House Prices and Household Spending

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

And medium– term trend growth may have fallen moderately

35. Following the widespread repricing of risk, corporates may face greater difficulty securing external finance for productive investment (including R&D) and entry into new businesses. This would likely lead to softer growth in capital stock and factor productivity. Moreover, net inflows of immigrant workers—an important source of economic growth recently—may slow with activity and sterling weakening.

B. Outlook in the Central Scenario

Taking the above factors into account, staff project a moderate slowdown

36. Economic momentum eases in 2008 as constrained real household income growth due to higher consumer prices and prospective weaker employment growth, together with a deceleration in lending, curbs consumption (Table 3). Residential investment is assumed to fall sharply and business investment also weakens significantly. On the supply side, activity in the financial services and property–related sectors are particularly hard hit. These factors will be compounded by the projected slowdown in the U.S. and the euro area and its spillover to the U.K. But the impact of these shocks is offset by the underlying resilience of the U.K. economy, the boost to net trade from sterling depreciation, the operation of automatic stabilizers envisaged in the 2008 budget, and the recent monetary loosening. And, although the U.K. and the U.S. face somewhat similar shocks, there are also notable differences that distinguish the near–term outlook for the two countries (Box 2).

United Kingdom and United States Compared

The apparent macroeconomic similarities between the U.K. and U.S. could suggest that a similar slowdown is likely in the U.K. Credit and housing booms, hitherto strong currencies, high household indebtedness and low savings rates, and external imbalances are shared characteristics. Indeed, with external adjustment underway in the U.S., U.K. adjustment may be even more challenging given consequent slowing export market growth.

Although a flat path for GDP as forecast for the U.S. cannot be ruled out, there are also notable differences that could mitigate such an outcome. Specifically, partly reflecting tighter loan standards and monetary policy (and so less extreme introductory “teaser” rates), mortgage delinquency patterns are more favorable than in the U.S. Subprime loans constitute about 6 percent of the total mortgage market in the U.K. compared to 13 percent in the U.S. And in contrast to the U.S. where credit quality has declined notably in recent years, credit standards in the U.K. appear to have been relatively stable (see charts below). Thus, the abrupt creditor retreat from the large low– quality segment of the U.S. credit market is unlikely to be repeated in the U.K. Furthermore, residential investment peaked at a lower level relative to GDP (3½ percent versus 6 percent), and the relative openness of the U.K. economy allows the exchange rate to play a larger cushioning role. On this basis, the U.K. slows down in the central scenario, but not as sharply as the U.S., despite the more accommodative monetary stance in the U.S.

uA02fig10

US subprime and alt‐A mortgage 60 days+ delinquncy across vintages

(Percent of original balance)

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

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UK non‐conforming mortgage 90 days+ delinquncy across vintages

(Percent of original balance)

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

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U.S. and U.K. Compared

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

37. Overall growth slows to 1¾ percent in 2008 and 2009, opening up some slack (Text Table 3). Though economic activity accelerates from the trough in end–2008, it remains below potential in 2009. With revival of external demand and lagged pass–through of the earlier sterling depreciation, net trade contributes further in 2009. The output gap starts narrowing in 2010.

Text Table 3.

GDP Growth

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Staff forecasts are updated in the staff supplement.

uA02fig13

U.K. Growth

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

38. Inflation is expected to remain above target through 2008 and 2009. Although food and fuel prices remain elevated, continued wage moderation and a lack of second–round effects alongside the disinflationary impetus from slower growth should foster a return to target by 2010.

C. Risks to the Outlook

Risks to the central case projections are broadly balanced, but downside risks warrant particularly close attention

39. The downside risks include a major credit squeeze or dramatic house price corrections, with both risks being relatively low–probability but high–impact events.

  • The contraction in wholesale funding for institutions and the protracted investor caution in respect of default and liquidity risk underscore the fragility of confidence. Even if the specter of an outright failure of another medium–size or larger institution is avoided, aggregate credit supply could nonetheless drop sharply. The risk of adverse feedback loops—from curtailed credit to asset (including commercial property) price falls, to a capital squeeze in banks, to curtailed credit supply—is real. And if another institution does fail, then the broader impact could be severe if the authorities prove unable to ring fence the problem.

  • One source of adverse feedback loops could be a dramatic fall in house prices. If they were to drop a cumulative 30 percent in 2008 and 2009, with other aspects of the international and U.K. environment remaining as in the base case, the growth impact could be contained to within ½–1 percentage point of the baseline in 2008–09. This robustness reflects the previously mentioned econometric evidence (¶39) and also the stability of recent U.K. mortgage underwriting standards and the creditor– friendly bankruptcy arrangements.4 But outcomes could turn out to be considerably worse if the house price collapse occurs alongside other (unrelated) negative shocks to output and employment.5

  • These downside risks to activity could be aggravated by inflation, which could curtail the scope for offsetting monetary policy action. If high food and energy prices unsettle inflation expectations and nominal wage discipline, notwithstanding weaknesses in activity, monetary policy flexibility will be lost.

40. Against this, upside risks come in various forms, but, in contrast to those on the downside, they are moderate–probability low–impact events.

  • Mortgage lending aside, aggregate credit supply could, as it has done since August 2007, remain resilient. The banking system could ride out the storm of losses and liquidity constraints by postponing dividends, capital raising efforts, widened banking spreads, and the support of various official initiatives. Even with wholesale– funded institutions contracting, there are signs that banks with strong retail funding may step into the gap in the market, thereby supporting aggregate credit supply. And with corporate savings historically high, internal funding by firms could replace faltering external credit, with the inter–firm credit market potentially replacing, at least partially, intermediation through troubled banks.

  • Furthermore, even to the extent that aggregate credit supply shocks occur, the underlying resilience of the economy—the fruit of two decades of substantive reform—could more effectively offset the associated output and employment costs than is assumed in the central case.

  • And as part of this, wage growth and hence inflation risk may remain contained (Text Table 4), reflecting the liberalization of U.K. product and labor markets, increased openness to migratory labor flows, and the underlying credibility of the U.K. inflation targeting framework. If so, monetary policy flexibility will be retained with attendant benefits for activity.

Text Table 4:

Private Sector Earnings 1/

(y–o–y change, in percent)

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Source: Bank of England, Inflation Report, May 2008.

Based on the monthly average earnings index. Three–month average measures.

Average of private sector settlements over the past twelve months.

Percentage points.

IV. Implications for Macroeconomic and Financial Sector Policies

A. Fiscal Policy

Budget consolidation will be essential to rebalance demand, and adhere to the debt rule6

41. The 2008 budget anticipates a neutral fiscal stance. It assumes below–trend growth of 1¾ –2¼ percent, with the headline fiscal deficit increasing to 2.9 percent of GDP, avoiding a procyclical tightening. Medium–term objectives imply a cumulative structural adjustment of 1½ percent of GDP by 2012, with two–thirds of the adjustment in 2009 and 2010 (Table 5 and Text Table 5). In this context, net public debt remains just below the authorities’ ceiling of 40 percent of GDP (excluding debt associated with the nationalization of Northern Rock), and external imbalances remain large once the downturn in 2008–09 passes. Staff, however, project weaker–than–budgeted balances in 2008—specifically, a deficit of 3.3 percent of GDP—and over the medium term.7 This largely reflects lower growth projections and lower revenue buoyancy from the financial sector. In this context, even if the planned fiscal adjustment in cyclically–adjusted terms is implemented as planned, the debt ceiling would be breached as early as 2009. And if output continues to evolve thereafter as staff project, debt would not return below the ceiling on announced fiscal policies, abstracting from debt–stock adjustments and prospective revisions to national accounts data (See ¶59).

Table 5.

United Kingdom: Public Sector Budgetary Projections

(Percent of GDP and percent of potential GDP)

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

Staff projections are based on the change in the cyclically–adjusted overall balance in the authorities' budget 2008 projections, but with the staff's growth and potential output projections. Official estimates are based on official projections of growth and potential output.

Including depreciation.

End of fiscal year using centered–GDP as the denominator; excluding Northern Rock.

Text Table 5:

Fiscal Balances and Public Debt

(In percent of GDP)

article image
Sources: Budget 2008 and staff projections.
uA02fig14

Overall Balance

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

uA02fig15

Current Balance

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

42. With underlying external imbalances still large, the terms of trade shocks enduring, and concern with output risks giving way to concern with inflation risks, strong fiscal consolidation is warranted over the near– to medium term. For 2008, following tax changes announced in May, some structural slippage has already occurred on the revenue side. Any slippage due to discretionary policy action in the projected 2008 outturn should be corrected in the 2009 budget. More generally, with growth projected to return to trend during the course of 2009, and the likely breach of the debt rule, the planned cumulative structural adjustment of 1 percent of GDP in 2009 and 2010 should be regarded as a minimum. And if nominal wage discipline slips or if the medium–term outlook for the current account deteriorates relative to official projections, additional fiscal adjustment may be needed to secure external and domestic stability.

B. Monetary Policy

Monetary policy should remain firmly focused on price stability by preventing second– round effects of cost pressures

43. With CPI inflation, which has been above target for some time, set to rise even further and remain high in the near term, there is a risk that businesses and consumers will expect inflation to be persistently above 2 percent. Tight monetary policy and subdued growth will be required to prevent elevated inflation expectations from getting embedded into wages and prices.

44. Given the planned fiscal stance, the challenge for the monetary authorities is to balance the upside risks to inflation against the potential disinflationary effect from downside risks to output. In the staff’s central scenario, the broad strategy should be to allow slack to develop in the economy to reduce upside risks to price stability and return inflation to its target level in about two years, consistent with the flexibility in the inflation targeting framework to respond to shocks. House price declines should affect the policy rate only if they reduce demand more than anticipated. This scenario incorporates the modest tightening of the monetary stance implied by holding the bank rate constant, given the increase in money market spreads and the link between many financial contracts and 3–month LIBOR. At the same time, financial sector stabilization initiatives have reduced downside risks to output from that source, diminishing the case for a further relaxation on that account.

45. Accordingly, the current halt in monetary policy easing is appropriate, and the next move in the bank rate needs to be assessed in light of the evolving outlook for inflation. Risks on both sides appear balanced. On the one hand, there may be room for additional policy easing if there is evidence of reinforcement of disinflationary factors, such as unexpected output weakness or deceleration of nominal wages. A tighter fiscal policy than anticipated would also provide room for easing. On the other hand, should signs emerge that wage restraint will not continue, or that medium–term inflation expectations rise further, an increase in the bank rate may be necessary to send a strong signal on this score.

C. Financial Sector Policies

Initiatives to strengthen bank capital remain critical

46. In light of continued illiquidity in money markets and perceived vulnerabilities of banks’ balance sheets, steps are needed to restore confidence and ease pressures. Several initiatives are underway, as outlined in the Bank of England’s April 2008 Financial Stability Report. For example, the Bank of England is reviewing its money market operations with a view to introducing a new permanent facility that learns from the experience of the SLS. In addition, steps are underway to improve the pricing of risk and strengthen risk management as envisaged in the recent report of the Financial Stability Forum, alongside greater regulatory emphasis on liquidity risk management, stress testing, and contingency funding. A critical additional element is the need for banks to raise capital to signal their ability to withstand potential shocks.

47. Although U.K. banks are reporting regulatory capital ratios above required levels, markets remain skeptical about bank robustness. Generally, concerns focus on declines in net income due to higher interest expenses from money market funding, weakness in the mortgage market, and accounting losses due to falling reference prices (particularly for sub– prime exposures). But in addition, even where losses have been announced and capital raised, there are concerns that these adjustments focus on banks’ trading books, with prospective losses from credit impairment yet to be addressed. In this context, the markets appear to be downplaying risk–based and internal capital measures in favor of simpler (but more transparent) equity measures such as an equity to asset ratio, with greater importance given to core (i.e. nonhybrid) equity. For those banks less able to bolster capital by recourse to new equity issues, options to postpone dividends, sell assets, and other such broader capital– raising initiatives may be necessary.

V. Policy Frameworks

The U.K.’s policy frameworks are under pressure

48. As noted above, although the inflation–targeting regime is confronted by difficult circumstances, its essential structure remains sound. But the fiscal and financial stability frameworks need reform.

A. Fiscal Rules

The rules–based fiscal framework aims to improve credibility and transparency

49. The framework comprises two rules, together with periodically issued medium–term spending objectives:

  • A sustainable investment rule. For the current cycle, this is expressed as a commitment to maintain net public debt below 40 percent of GDP and, since 2003, to observe this limit in every year.

  • A golden rule, measured by the cumulative current balance since the beginning of the cycle, as a percent of GDP.

  • Compliance with the two rules is supported by comprehensive spending reviews which set departmental spending limits three years ahead.

Like inflation–targeting, this is a framework of constrained discretion

50. Although medium–term sustainability is emphasized, discretion is considerable in several dimensions—annual budget balances can swing substantially, revenue and expenditure ratios are unanchored as long as they move together, the headroom to be maintained against the rules and the treatment of debt stock adjustments are undefined, and the authorities largely self assess compliance. And public debt remains low compared to other EU advanced economies, even though its continued rise in recent years goes counter to the reductions achieved by most of these countries.

uA02fig16

General Government Net Debt, 2007

(in percent of GDP)

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

uA02fig17

Change in Public Net Debt Ratio in EU Countries, 2002‐07

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

However, some use of this discretion has created difficulties

51. In particular, despite output close to potential over the entire decade, headroom under the debt rule has been steadily eroded (see Annex 4). Expenditure has tended to exceed the multi–year projections, even when the latter anticipated significant increases. Recent revisions to external data underscore the toll the associated high deficits—in the context of buoyant private demand—took on the external balance. And in light of the uncertainties surrounding the cyclical position of the economy, the authorities have not yet established an end point for the cycle that began in 1997, complicating assessment of adherence to the fiscal rules.

The debt rule should be maintained, but other adjustments to the rules to constrain discretion may be appropriate

52. The net debt ceiling underpins the medium–term and sustainability focus of the current framework, which reflects aging and other factors (Figure 7). In this light, any softening of the ceiling—even a reversion to casting it “over the cycle”—would be inappropriate, especially at the current juncture because of elevated inflation expectations, current account developments, terms of trade losses, and the difficulty of establishing the credibility of a higher ceiling or an alternative framework.

Figure 7.
Figure 7.

Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one‐half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten‐year historical average for the variable is also shown.Definition of net public debt ratio in this exercise differs from official and staff projections, which use centered GDP as the denominator.2/ Permanent 1 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One‐time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2007, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

53. Indeed, a stronger medium–term fiscal path than that implied by the authorities’ plan would support the necessary shift from domestic to external demand and help secure headroom under this cap to accommodate stabilizers in future. Further, any leeway arising from prospective upward revisions to official estimates of GDP, such as those expected from revised estimates for financial sector value added, would best be applied to headroom under the debt ceiling, not to a relaxation of the recommended fiscal stance. If, however, the ceiling is breached in coming years, as appears likely, prompt announcement of plans to bring it back under the ceiling on a sustained basis and create the necessary buffers over the medium term to allow automatic stabilizers to operate will be critical.

The status of the spending guidelines should be raised

54. The net debt rule needs the support of other elements of the fiscal framework. In that regard, nominal spending caps are simple and transparent, facilitate multi–year expenditure planning, constrain upward expenditure drift directly, allow automatic stabilizers to operate on the revenue side, and strengthen fiscal resistance to inflation. Binding three–year global current expenditure ceilings could be set on a rolling basis—building on the system of three– year departmental expenditure limits as well as steps towards multi–year public service nominal pay awards—so that each new budget would introduce a further year, with limited scope for revision.

55. Cyclically–sensitive items such as unemployment benefits could be excluded if a contingency reserve to accommodate cyclical spending proves infeasible. Concern to secure investment spending could be reflected in adoption of a multi–year floor on investment. Medium–term policy on the revenue ratio would be implicit in the expenditure and debt targets. Adherence to the golden rule could still be monitored—much as nominal spending relative to target is now—but it would no longer play a primary role in the fiscal framework. Such a shift in emphasis would also reflect the success of broader policy frameworks, which have underpinned reduced economic volatility thereby diminishing the need to define fiscal or other rules “across the cycle.”

B. Financial Stability Framework

The post–August 2007 global liquidity turmoil highlighted weaknesses in the financial stability framework.

56. The design of the U.K. financial stability framework reflects several core principles. The “caveat emptor” approach implies that—consumer protection aside—investors large and small are expected to play a role in providing discipline to institutions, a principle reflected, among other things, in limited and partial deposit insurance cover. Relatedly, banks should be allowed to fail (as reflected in a series of closures in recent decades), subject to systemic concerns. Furthermore, supervision within the U.K. should operate on a consolidated rather than line–of–business basis to reflect and facilitate increased integration of financial firms. And cross–border supervisory matters are handled in a variety of frameworks, sometimes in an ad hoc manner reflecting individual firms’ circumstances. And finally, clearly demarcated responsibilities are assigned to the tripartite bodies—the Financial Services Authority (FSA), the Bank of England, and the Treasury.

57. Following the global freeze on liquidity since August 2007, these core principles have been questioned, notably in a series of thorough and transparent official reviews. The consequent official proposals for reform aim to correct shortfalls while retaining the core principles of the financial stability framework, and they go in the right direction.

The review of supervision of Northern Rock catalogues multiple failings, but endorses the supervisory framework

58. Deficiencies highlighted in the supervision of Northern Rock include insufficient resources devoted to the case, management and staff turnover, training, flow of information, and inadequate proactiveness—all undermining FSA decision–making in that case.

59. In learning lessons from this review, two issues are key. First, linkages between the aggregate market risk factors highlighted in the authorities’ various “Stability Reports” did not translate into specific supervisory follow–up, neither for Northern Rock nor for other cases. Second, despite multiple risk management failings in many financial institutions, it appears to have required the trigger of an overt crisis to generate close supervisory follow–up. The FSA has acknowledged the need for more formal links between risk identification and follow–up in respect of individual institutions and more assertive supervisory action when a problem is uncovered in an institution.

Liquidity regulation remains a critical challenge

60. An FSA discussion document sets out initial considerations for reform. These include: reemphasis on the responsibility of bank boards and management in liquidity risk management, enhanced use of stress tests by regulators, introduction of quantitative liquidity requirements, and further buffers of highly liquid assets to ensure survival under stress. As noted in the Bank of England Financial Stability Report, stress tests alone are insufficient and should be integrated with well–developed contingency funding plans.

61. In taking these matters forward, two issues are key. First, although the Northern Rock crisis was triggered by illiquidity, solvency concerns led to loss of depositor confidence. Regulators need to consider capital and liquidity requirements jointly. Second, the role of strengthened disclosure to markets in forestalling liquidity difficulties can be developed in various dimensions, including greater regulatory reporting to investors and markets. These matters are being considered in a number of international fora and progress is underway in the U.K. as part of the adoption of Basel II.

Establishment of a special framework for bank resolution, along with other key reforms, are also under preparation

62. Key proposals, outlined in the tripartite consultation paper8, include:

  • A special regime aimed at the orderly resolution of failing banks prior to formal insolvency. Actions on a failing bank would be based on regulatory triggers based on quantitative and qualitative criteria.

  • Increased coverage of deposit insurance aimed at raising compensation limits, facilitating compensation of depositors within one week of a bank closing, and improved arrangements for funding the deposit insurance scheme.

  • Strengthening the tripartite arrangements for financial stability among the government, the Bank of England, and the FSA, with particular focus on strengthening the communication with the public and providing a statutory basis for the Bank of England’s role in maintaining financial stability.

  • Effective cooperation across borders, with a view to improving the coordination of approaches to international financial stability issues, introducing an early warning system on global financial risks, and improving cross–border crisis management. This will include initiatives at both the EU and global level to ensure satisfactory crisis management procedures.

The proposals are sound but will require development in various areas

63. The special resolution regime provides the authorities a key extra tool to pre–empt outright bank failure and to manage it, reducing the burden on other elements of the financial stability framework to address these matters. Determination of the basis on which the regime is triggered has to set an appropriate balance between addressing regulatory forbearance and unnecessary actions. Although the variety of possible circumstances rules out the possibility of an exhaustive ex ante definition of trigger conditions, unconstrained discretion may weaken the effectiveness and legitimacy of the regime. Accordingly, an approach whereby the regime is presumed to be triggered when specified thresholds are crossed but where it may be triggered in advance of those thresholds, would be appropriate. But however triggered, the legal basis for actions under the regime needs to be secure in a broad range of contexts if the special resolution regime is to play its pivotal role in the new financial stability framework.

64. In similar vein, and in light of the internal FSA review of its supervision of Northern Rock, it may be appropriate to elaborate further the actions presumed to be taken once institutions cross specified thresholds. This could involve simply strengthening the FSA internal information system—automatically informing senior management when thresholds are crossed. Or it could go further, to establish in appropriate cases more concrete supervisory actions that are “presumed” to be taken in such cases. In this context, balances have to be struck between accommodation of unique circumstances and forbearance.

65. There appears also to be scope to strengthen further the data available to markets on individual firms and the information–sharing arrangements between the tripartite authorities. Although listed firms have extensive disclosure requirements—including for significant developments between formal audited reports—greater, more frequent, and more standardized reporting to markets of financial information of the banking system and individual banks could address information asymmetries which arise, notably in fast–moving crisis episodes. In addition, it is key that all tripartite authorities are appropriately informed to fulfill their assigned roles. In this light, proposals to give the Bank of England a legal basis for its financial stability functions and to establish a Financial Stability Committee to assist in these matters have merit.

66. Finally, the policy responses to the Northern Rock run and related turmoil in financial markets have signaled a fundamental shift in policy on bank stability. In particular, the extension of public guarantees to banks, provision of liquidity by the Bank of England to markets, and proposed reforms to deposit insurance have all signaled that the “caveat emptor” principle will not be applied as extensively as hitherto. As this principle was a key counterpart to the U.K.’s “principle based” regulatory philosophy, the post–Northern Rock de facto diminution of market discipline may require corresponding shifts in the nature of supervision. The proposals on bank resolution are one element of that shift. Other steps may be needed in this context along with a more transparent rules–based approach that promotes early intervention and assurance that the relevant authorities are provided with access to sufficient resources.

VI. Authorities’ Views

67. There was broad agreement with the staff on the major macroeconomic concerns facing the U.K. and that strong policy frameworks and macroeconomic outcomes have situated the U.K. well to face the twin shocks of financial market turmoil and commodity price rises. There were, however, some divergences in views on the short–term outlook and on the appropriate adjustments to fiscal policy and policy frameworks.

68. The twin shocks will lower growth and raise inflation. But relative to the Bank of England, the Treasury felt the impact on activity would be somewhat more muted and shorter–lived, notably in respect of the credit shock. Both underscored that consumption growth would likely be moderated by continued slow growth in real take home pay, and both noted the benefits of sterling’s depreciation on net exports. The Special Liquidity Scheme and capital raising efforts by banks were cited as contributing to increased confidence in financial markets.

69. The ongoing housing market correction is regarded as contributing to the broader rebalancing of the economy. And even if prices were to fall further and faster than anticipated, the impact on consumption growth is considered likely to remain muted as consumption responds more to household income than to asset price developments.

70. The fiscal authorities welcomed the staff endorsement of the Budget judgment for 2008, but felt that the case for greater adjustment than planned in 2009 to address discretionary policy slippage or external weakness had to be balanced against short–term output stabilization concerns. Thus, they remained committed to adhere to the debt and golden fiscal rules, which provide for some flexibility in this regard. The next assessment of fiscal objectives and planned discretionary measures, taking into account the broad sweep of developments, would take place in the context of the next pre–Budget report, and subsequently in the 2009 Budget. The authorities also remain committed to the medium–term expenditure targets laid out in the Comprehensive Spending Review, as well as public sector pay restraint through multi–year agreements, which they saw as contributing to overall wage restraint in the economy.

71. On inflation, the Monetary Policy Committee reflects a range of views of the risks. Some members focus on concerns about second round effects and impairment to credibility of the inflation targeting framework as a result of a prospective significant deviation from target more prolonged than in the recent past, but others emphasize muted labor market responses and concerns with the disinflationary impact of credit–crunch effects on output. Most recently, the balance of views has favored holding Bank Rate constant, pending further clarification of the relative weight to be given to the two risks. Following the May 2008 CPI data, the Governor’s letter to the Chancellor noted that inflation is likely to rise above 4 percent in the second half of 2008 and remain markedly above target well into 2009, and that the MPC is aiming to return inflation to target within its normal forecast horizon of around two years.

72. Turning to the external accounts, the authorities emphasized a number of concerns with the reliability of the data. In particular, trade data have been distorted by VAT–related fraud, the income accounts have indicated significant shocks which have been difficult to interpret, and the IIP accounts have various measurement difficulties, including measuring FDI at book rather than market value. Although the negative trends indicated in recent years were broadly correct, the precise numbers were not reliable. Subject to that qualification, the authorities agreed that external trends had become more of a concern in recent years and remained under review. In that light, they noted that the recent depreciation of sterling had lowered it back into the range for the real effective rate in which it had traded over the past decade or so, and that competitiveness against the euro area—a key trading partner—was stronger.

73. On the policy frameworks, the authorities agreed that changes to the Bank of England’s inflation–targeting mandate would be counterproductive. On the sustainable debt rule, they reaffirmed their commitment to adhere to it, but also underscored that fiscal stabilizers should be allowed to operate. In light of the premium on flexibility over the cycle and the protection of investment, they also regarded the golden rule as more appropriate than the suggested nominal spending ceilings, even if the latter are rooted in the three year comprehensive spending review.

74. On the financial stability framework, the authorities agreed that the tripartite framework was fundamentally the right one, and that the ongoing reform work was to enhance the operation of this framework and the tools available to the authorities in maintaining financial stability. As to the detail, the authorities preferred to retain considerable discretion in the execution of supervisory practices, including in regard to application of the trigger in the proposed SRR. The variety of circumstances and the difficulty of specifying appropriate thresholds in advance appeared to rule out “hard” thresholds. That said, additional flows of management information triggered automatically as institutions crossed thresholds could help. Treasury officials were also confident that a firm legal basis for actions under the special resolution regime would be obtained once the framework goes into effect.

75. On transparency for individual financial firms, the authorities noted that practices will be upgraded in line with Pillar 3 of the Basle II accords, and emphasized the distinction between more data and more information. The burden on firms of collecting the former could only be justified if users were better informed, rather than “blinded” by the quantity of additional information. Although there was likely some benefit from greater frequency of formal reporting to markets, listed firms were already obliged to report “significant” developments even between regular reports, and unless all such data issues were audited, some confusion could arise from the different status of data issued.

Annex I—External Sustainability9

The underlying trend in the U.K.’s external balance has worsened in recent years, raising concerns about sustainability. Staff projections suggest that the current account deficit remains above equilibrium and the net asset position continues to erode in the medium term. Although risks of a disrupting external correction are low, the projected weakness in the outlook underscores the need for rebalancing activity toward net trade to ensure sustained external stability.

Recent developments

The U.K.’s net external liabilities are modest by international standards. At a deficit of 25 percent of GDP, the U.K.’s net International Investment Position is comparable to other advanced economies. The net debt position in part reflects the U.K.’s strong fundamentals, such as favorable demographics and a high trend growth relative to its major trading partners.

uA02fig18

The U.K.’s net IIP is comparable to other advanced economies;10

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

Note: Data refer to 2007 for the U.K., Iceland, Greece, New Zealand, Australia, the euro area, Canada, and Switzerland, and to 2006 for the others.

The U.K.’s external balance, however, has deteriorated substantially in recent years amid strong sterling appreciation. Although net investment income provided an exceptionally strong boost to the current account in 2002–05, the underlying trade deficits were widening. Prior to the second half of 2007, it might be argued that the strong income flows indicated a permanent rise in U.K. residents’ income and, hence, justified the weakening in net exports. This hypothesis, however, was undermined by subsequent data revisions, which revealed that net income fell sharply in 2006–07 to only about ½ percent of GDP. Indeed, if it were not for the large write–offs by foreign banks at end–2007 in light of the financial turmoil, the current account deficit in 2007 would have likely reached 5 percent of GDP—a level not seen since the eve of the notable current account adjustment episode in 1990-97.

uA02fig19

but the current account has deteriorated in recent years…

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

The net IIP has worsened alongside. Although measurement issues may qualify inferences drawn from the observed level of net assets, the consistent downward trend since 2003 points to a significant erosion of the U.K.’s underlying external position. During 2003–07, the U.K.’s net liabilities more than quintupled, rising from 4 to 25 percent of GDP.

uA02fig20

and the external position has weakened…

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

The external deterioration largely reflected the change in domestic savings behavior. More than half of the rise in external deficits since 2003 has been attributed to the decline in the household savings ratio, which occurred even though households’ net financial wealth remained stagnant. A decrease in precautionary saving motive following a prolonged period of economic stability was likely an important factor, but the decline in savings might have been driven more by the rapid rise in house values.

uA02fig21

…as households saved less amid the housing cycle upturn.

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

The U.K.’s competitiveness has weakened. Relative nontradable prices have risen, dampening export performance. The U.K. share of global goods imports has fallen while the services counterpart has remained flat. In what may be a worrying sign for the future trend, the U.K.—like some other advanced economies—has been losing trade business with such dynamic regions as Asia and oil exporters, which will likely continue to be increasingly driving global demand. Even after netting out intra–Asia trade, data show that developing Asia has reduced the share of its imports from the U.K. from 3.7 percent in 1997 to 2.2 percent in 2006, a reduction of 40 percent. Oil exporters have also lowered their share of spending on U.K. imports by a similar amount. Part of the deterioration has been driven by the strength of sterling. Notwithstanding the substantial depreciation in recent months, as of May 2008 the U.K.’s REER is still 5–10 percent above its equilibrium level, according to a variety of methodologies.11

uA02fig22

The U.K. has consequently lost competitiveness…

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

…and trade business with dynamic regions.

article image

Outlook

To facilitate risk assessment, staff projections of the U.K.’s current account and net IIP are portrayed in fan charts. This approach allows a comprehensive presentation of the degree of uncertainty behind the central projections and of the balance of risks around them. The econometric methodology used in creating the fan charts exploits both low–frequency cross– country and higher–frequency U.K.–specific time–series data. First, we estimate in panel regressions the behaviors of the current account and valuation change of the IIP as a function of global growth, the economy’s own growth, nominal and real exchange rates, lagged IIP, and individual country fixed effects.12 Second, we estimate with a vector autoregressive (VAR) model the statistical interdependence among the variables key to the U.K.’s external sector and, accordingly, simulate constellations of shocks, which are then fed into the panel estimations to generate our projections.13

The current account deficit is projected to stabilize at 3–4 percent of GDP. In the central projection, the deficit remains at around 4 percent of GDP in 2008, as the expected pickup in net trade is offset by unfavorable terms–of–trade movement. Thereafter, the current account is projected to improve slightly before flattening. Risks around the baseline are roughly balanced. According to the projection, there is a high probability—about 70 percent—that by 2013 the external deficit would remain above the level assessed to be the equilibrium for the U.K. (about 2 percent of GDP) using CGER methodology.

uA02fig23

With the current account projected to remain in significant deficit…

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

Note: The darkest area represents the 10 percent confidence interval around the central projection. The band expands out in 10 percent increments, with the lightest area representing the 80 percent confidence interval.

The net IIP is projected to be on a downward trajectory in the medium term. The U.K.’s external position is forecast to strengthen modestly in 2008–09, largely reflecting favorable valuation changes as sterling weakens.14 Beyond 2009, however, the net IIP is projected to shift to a deteriorating trend, as the effect of valuation change dissipates and the current account remains in deficit. With upside risks approximately balanced against downside risks, the projection suggests that the U.K.’s net IIP is likely to worsen modestly in the medium term.

uA02fig24

…the net IIP will likely keep trending downward.

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

Note: The darkest area represents the 10 percent confidence interval around the central projection. The band expands out in 10 percent increments, with the lightest area representing the 80 percent confidence interval.

A main source of uncertainty behind the projections is the strength of sterling going forward. The recent sterling depreciation could only be partly explained by the movement in interest rate differentials. As the Bank of England’s May Inflation Report points out, the other driving forces likely include an increase in the risk premium associated with sterling assets and a reassessment by market participants of sterling’s sustainable value; but the relative importance of these factors and, thus, the persistence of the downward pressure on the currency is not entirely clear. Looking ahead, the extent to which there are sustained shifts in U.K. residents’ savings tendencies and in the relative attractiveness of U.K. assets would be among the key determinants of sterling’s medium–term strength.

Assessment

At present, the U.K. faces little threat to external stability. Its net external liabilities—though already modest—might have been overstated in the official data. As previous analyses (e.g., Nickell, 2006; and Whitaker, 2006) point out,15 official statistics—with FDI generally measured at book rather than market value—might have considerably underestimated the U.K.’s FDI assets and the related valuation changes, and hence, the overall net external position. Moreover, the U.K. possesses a robust economic infrastructure—e.g., free access to international capital markets, a high degree of data and policy transparency, and a flexible exchange rate regime—that supports efficient pricing of sterling assets and further diminishes risks of a destabilizing external correction.

Nevertheless, the projected weakening of the U.K.’s external position raises concerns about medium–term vulnerability. Although it does not pose major risks, the recent substantial sterling depreciation underscores the fact that shocks can trigger a considerable repricing of the currency. Sustained buildups in net liabilities—as projected—would amplify risks of deep and abrupt exchange rate reevaluations, thus leaving the economy increasingly susceptible to shocks. This vulnerability is further compounded by risks to the U.K.’s external position from asymmetric valuation changes; these changes can be highly significant, given the large and growing gross size of the U.K.’s external assets and liabilities (now over four times GDP).

uA02fig25

The outsize gross position implies risks to net IIP from valuation changes.

Citation: IMF Staff Country Reports 2008, 271; 10.5089/9781451814330.002.A002

Note: Data refer to 2007 for the U.K., Switzerland, Iceland and the euro area, and to 2006 for the others.

In this light, a continued commitment to structural fiscal consolidation is important. There is a case for the government to take measures to offset distortions that may result in undersaving by the private sector. In particular, strengthening public–sector savings would bring an important marginal contribution to the U.K.’s savings dynamics. Further, by reducing the burden on monetary policy, tighter fiscal policy would facilitate rebalancing activity toward external demand.