United Kingdom
2010 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the United Kingdom.

The U.K. economy is on the mend, but crisis-related scars still need healing. The challenge ahead will be to ensure sustainable recovery and balance sheet repair while remaining flexible to respond to shocks. A highly accommodative monetary stance is required to offset the contractionary impulse from fiscal policy and keep inflation close to target. Risks to this scenario are substantial, and policies will need to adapt if they materialize. The government should continue to fortify fiscal institutions. Efforts should continue to strengthen financial sector health.

Abstract

The U.K. economy is on the mend, but crisis-related scars still need healing. The challenge ahead will be to ensure sustainable recovery and balance sheet repair while remaining flexible to respond to shocks. A highly accommodative monetary stance is required to offset the contractionary impulse from fiscal policy and keep inflation close to target. Risks to this scenario are substantial, and policies will need to adapt if they materialize. The government should continue to fortify fiscal institutions. Efforts should continue to strengthen financial sector health.

I. The Economic Agenda

1.The new Conservative-Liberal Democrat coalition government has launched a number of important policy initiatives in its first few months in office. Its first budget, released in June, lays out an ambitious multi-year plan for deficit reduction—the centerpiece of the coalition agreement. To underscore its commitment, the government has created an independent Office for Budget Responsibility (OBR), which produces macroeconomic and fiscal forecasts for the budget and assesses whether budget plans are adequate to meet government-set fiscal targets. Separately, the government has set out to revamp the UK’s framework for financial regulation and supervision, consolidating key responsibilities in the Bank of England (BoE).

2. These initiatives come in response to significant challenges, as the policy focus shifts from immediate fire-fighting to post-crisis repair. With crisis memories still fresh and lingering risks, the priority is to preserve confidence. To this end, the authorities going forward will need to implement announced plans to restore fiscal sustainability and maintain monetary stimulus to ensure a smooth rebalancing of the economy, while laying the groundwork for a safer financial system.

  • Recovery from the financial crisis is underway, despite continued headwinds (Figure 1). After six quarters of deep recession, the economy started growing again in late 2009, led by a classic turn in the inventory cycle. More recently, final private demand has also rebounded from low levels (Figure 2), causing GDP growth to surprise on the upside. The recovery has been buttressed by the authorities’ forceful policy response, including large-scale interventions to rescue the financial system, temporary fiscal stimulus (though this started phasing out in 2010) along with full operation of automatic stabilizers, and unprecedented monetary easing. However, sterling depreciation has not yet boosted net exports as much as expected, and signs of a softening global recovery have dampened the outlook for external demand. Domestically, still-strained household and bank balance sheets remain a headwind for growth. Meanwhile, inflation has surprised on the upside as a series of price level shocks has more than offset the moderating effect of sizeable economic slack.

  • The challenge going forward will be to ensure sustainable recovery and balance sheet repair while remaining flexible to respond to shocks. In staff’s central scenario, fiscal consolidation will mend the fiscal position while stimulative monetary policy continues to support private and external sector-led growth. However, there is significant uncertainty surrounding the underlying recovery momentum in the UK and globally. The operation of automatic fiscal stabilizers provides an important safeguard against risks on both sides. Moreover, monetary policy can flexibly increase—via more quantitative easing—or withdraw stimulus so as to deal with a broad range of shocks. Financial sector policies, in turn, face the difficult task of moving to a stronger financial system while ensuring adequate credit supply during the transition.

Figure 1.
Figure 1.

Real Sector Developments

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Bank of England, British Chambers of Commerce, Office of National Statistics, MarkitEconomics.1/ Bank of England Agents’ Survey, manufacturing.2/ Bank of England Agents’ Survey, services.3/ GfK Consumer Confidence Barometer.
Figure 2.
Figure 2.

Behavior of Key Macro Variables Around Recession Times 1/

(Last pre-recession quarter t-1 = 100, unless otherwise noted)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; and IMF staff calculations.1/ The previous two recessions lasted five q uarters each, i.e., from t-0 through t-4.

II. Progress in Rebalancing and Deleveraging

3. Continued economic recovery depends on a sustainable revival of private spending, while the public sector retrenches. The UK economy entered the crisis with a number of pent-up imbalances: overheated property markets, low household saving, high private sector debt, a large and overleveraged financial sector, and high external deficits and debt. Each of these imbalances has corrected to some extent, albeit at the high cost of a protracted economic downturn. Moreover, some of the earlier imbalances have merely shifted from the private to the public sector, as the government has accommodated a large drop in revenue and bailed out ailing banks. In the period ahead, the government is set to redress its unsustainable financial position, leaving other sectors to reemerge as the drivers of growth. Households are likely to remain thriftier than before the crisis, but have room to gradually raise consumption as labor market concerns subside and saving rates settle somewhat below their recent peak. The corporate sector, in turn, is projected to lessen its cash preservation effort, as the demand outlook firms up and credit constraints continue to ease. Improved net exports should simultaneously stabilize the external balance around a lower and sustainable deficit. Overall, this gradual rebalancing of the economy is projected to allow moderate growth, with considerable risks on both sides.

uA01fig01

Financial Balances of Economic Sectors

(Percent of GDP, rolling 4-quarter average)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; and IMF staff calculations.

A. Sectoral Adjustments and Evolution of Financial Balances

4. The deleveraging of household balance sheets was a key feature of the downturn, but has recently begun to ease. Private consumption declined considerably during the recession, as households responded to mounting economic uncertainty and plunging asset prices (Figure 3). Lower net tax payments cushioned the loss in labor income, but the gross household saving rate surged to a peak of 7¾ percent in mid-2009—up six percentage points from its pre-crisis levels. This shift to frugality mimics developments during historical financial crises elsewhere and is likely to have at least some permanent component. Indeed, compared to the UK’s OECD peers, household saving rates are still low and debt levels high, reflecting widespread home ownership and high house price levels. Nonetheless, the saving rate already fell back to 4½ percent in the first half of 2010, as recovering asset prices and a stabilizing labor market lifted confidence. At the same time, record-low interest rates significantly reduced debt service costs.

Figure 3.
Figure 3.

Financial Position of Households

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver Analytics; OECD; and IMF staff calculations.1/ For 2009: staff estimate.2/ Data for end-2008
uA01fig02

The UK household saving rate rose sharply during the recession, though not to levels observed elsewhere

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver, OECD Economic Outlook
uA01fig03

Large policy rate cuts have provided significant relief to indebted households, given the dominance of variable-rate mortgages

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Parliament of Australia, Report on HousingAffordability; European Central Bank; and Haver

5. The labor market has proven more resilient than expected. Although any significant increase in unemployment entails hefty human costs, employment losses have been relatively moderate compared to previous recessions (Figure 4). Unemployment initially rose from 5½ percent to 8 percent, but then stabilized at this level for most of the past year and has edged down slightly in recent months. This resilience partly reflects lower net immigration, reduced labor force participation, and some public sector hiring. However, the data also suggest some labor hoarding in the private sector, induced by wage restraint, firms’ desire to retain talent, and expectations of a recovery in demand.1 Business surveys continue to show slack in the labor market and generally little difficulty in recruiting staff, especially in services.

Figure 4.
Figure 4.

Labor Market Developments

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver Analytics; Office for National Statistics; and IMF staff estimates.1/ Estimates based on provisional data from the International Passenger Survey.
uA01fig04

Given the depth of the latest recession, the rise in unemployment has been moderate…

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; and IMF staff calculations.1/ t-0 denotes first quarter of recession.
uA01fig05

…implying a comparatively large decline in average labor productivity

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; and IMF staff calculations.

6. Residential property prices have recovered but remain below pre-crisis levels. House prices staged a faster-than-expected recovery in 2009, as financially strong buyers returned to a market still characterized by relatively limited supply (Figure 5). More recently, the upward momentum has dissipated, with the 3-month change in house prices turning negative. Overall, prices remain some 15 percent below their 2007 peak. At this level, valuations continue to appear stretched relative to income, although exceptionally low interest rates have boosted affordability, at least for now. Meanwhile, overall financing conditions are still tight, with average loan-to-value ratios on new first mortgages hovering at 75-80 percent, well below the ratios observed during the pre-crisis boom. Mortgage approvals and net lending amounts have also stayed at low levels. On the positive side, mortgage arrears and repossessions have eased from their (already moderate) peak rates.

Figure 5.
Figure 5.

Residential Housing Markets

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Bank of England; Haver; UK Communities and Local Government; UK Council of Mortgage Lenders; UK Department for Work and Pensions; UK Office for National Statistics; US Bureau of Economic Analysis; US Mortgage Bankers Association; and IMF staff estimates and calculations.
uA01fig06

Average of Halifax and Nationwide House Price Indices

(Percent)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; and IMF staff calculations.
uA01fig07

House Price Affordability

(Rolling four quarters, percent)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; UK Dept. for Work and Pensions; and IMF staff calculations.1/ Based on standard variable rate mortgage.

7. The relatively benign performance of the UK housing market partly reflects the (otherwise problematic) restrictiveness of the country’s planning laws. Although the UK experienced a strong boom in house prices prior to the financial crisis, construction of new units remained comparatively modest. Likewise, employment in the construction sector did not reach the heights observed in countries like Ireland, Spain, or the US. One important reason appears to be the UK’s strict planning law, which has allowed local administrations to severely restrain the designation of new building areas. As a result, excess capacity in the residential housing market remains limited even today. This situation has supported relatively high house prices, benefiting older, home-owning generations at the expense of younger households and driving up gross household indebtedness. Wide-spread affordability problems have also given rise to high public outlays for housing support—more than 1 percent of GDP in 2009/10—and reduced labor mobility.

uA01fig08

Housing Completions

(2000 Q1=100)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; and IMF staff calculations.

8. Businesses reined in spending during the crisis, but have recently shown signs of reviving investment activity. The nonfinancial corporate sector entered the recession with relatively solid financial balances, despite high debt levels. As demand contracted and the profit outlook deteriorated, firms cut back sharply on investment to preserve cash flow. From these unsustainably low levels, investment rebounded 13 percent (saar) in the first half of 2010. Recent surveys of investment intentions and falling spare capacity in manufacturing point to continued expansion going forward. Defaults on bank loans and company liquidations have increased from low levels since 2008, but appear to have peaked in 2009. Overall, the financial position of companies remains resilient, but there are areas of vulnerability, especially in commercial real estate, where prices are hovering one-third below pre-crisis levels.

uA01fig09

Nonfinancial corporates have generally maintained relatively solid equity cushionsin recent years…

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Bloomberg; and IMF staff calculations.1/ Statistics refer to a balanced panel of 160 nonfinancial corporates included in the FTSE All Shares stock index.
uA01fig10

…and the bankruptcy rate has already eased from its peak

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Source: Haver.

9. The recession has resulted in a sharp deterioration of the fiscal position (Figure 6). The headline public sector deficit (excluding financial sector interventions) increased from 2¼ percent of GDP prior to the crisis to 11 percent of GDP in FY 2009/10 (April 1—March 31). Much of the deterioration is estimated to be structural, reflecting permanent revenue losses and a sharp drop in potential GDP growth. By contrast, discretionary stimulus has contributed relatively little, especially because the previous government already started tightening fiscal policy in early 2010. The new government, in turn, has announced some additional spending cuts for 2010, followed by accelerated deficit reduction from 2011 onward. Nonetheless, general government gross debt has risen above 70 percent of GDP and is set to reach 85 percent of GDP by 2012, about twice its pre-crisis level. In addition, the government faces large contingent liabilities from its various financial sector interventions, even though direct net costs are estimated to be small so far.2 Importantly, funding conditions in the gilt market are currently quite favorable, reflecting in part investor confidence in consolidation plans (see Section IV). Indeed, UK sovereign bonds have enjoyed a safe-haven bonus in recent months, while market pressures in some Eurozone countries have intensified: the ten-year gilt yield was less than 3 percent in mid-October, more than 100 basis points below its mid-February peak.

Figure 6.
Figure 6.

Fiscal Developments

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: HMT, DMO and IMF staff estimates.1/ Negative of the change in cyclically adjusted balance.2/ Change in cyclical balance
uA01fig11

Contributors to the Increase in Gross General Govt. Debt between 2007-10

(Percentage points of GDP)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: HM Treasury, and staff estimates.
uA01fig12

Change in Nominal Yield on 10-Year Government Bond since Jan. 4, 2010

(Basis points)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; and IMF staff calculations.

10. Despite significant sterling depreciation, net export volumes have yet to pick up significantly. Sterling’s real effective exchange rate declined some 25 percent between mid-2007 and early 2009 and has since stabilized around this new level. Based on standard IMF methodologies, the currency appears to be broadly in line with fundamentals. However, the weaker exchange rate has not yet boosted net export volumes as much as expected. Instead, most of the depreciation has so far translated into stronger profit margins for exporters (Figure 7). Consequently, the current account deficit in 2010 is on track to be only slightly below the pre-crisis level of 2½ percent of GDP. Meanwhile, the depreciated exchange rate did improve the UK’s international investment position, as UK external assets have a greater foreign-currency component than external liabilities. However, the IIP has weakened somewhat in recent quarters on the back of higher asset valuations in the UK.

Figure 7.
Figure 7.

External Sector Developments

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver Analytics; and IMF, International Financial Statistics.
uA01fig13

Exchange Rate

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Source: Bank of England.

Estimates of Exchange Rate Valuation 1/

(percent)

article image

+/- indicates exchange rate over/undervaluation; see IMF Occasional Paper No. 261 for details on the methodology underlying the estimates in this table.

B. Deleveraging and Macro-Financial Links

11. UK Banks have made progress in repairing their balance sheets (see Figure 8 and companion Selected Issues paper for additional details on recent developments). All major banks have raised capital and reduced leverage. Moderate impairment charges, wider lending margins, and higher investment banking revenue have boosted system-wide earnings over the last year, and the two large, part-nationalized banks have returned to profit. The July 2010 EU-wide stress tests and associated disclosure confirmed the improved health of UK banks.

Figure 8.
Figure 8.

Banking Sector Indicators

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Bank of England, Bloomberg; company data; and IMF staff calculations.1/ Data series no longer available after Dec. 2009, but new series (covering all MFIs) suggests continuation of recent trend.
uA01fig14

Leverage Ratios of Major UK Banks 1/

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Source: Bank of England.1/ Adjusted assets over adjusted capital. Assets are adjusted by netting derivatives and adjusting for cash items, tax, and intangible assets. Capital excludes Tier2 instruments, preference shares, hybrids and intangibles.

12. Funding conditions have improved since the height of the crisis. Stress in sterling money markets eased significantly throughout 2009, as banks benefited from improving confidence and massive liquidity support, including through the BoE’s quantitative easing. As a result, the Libor-OIS spread fell back to almost pre-crisis levels. Longer-term funding markets also thawed, and banks issued considerable amounts of unsecured debt, gradually reducing their reliance on the government’s Credit Guarantee Scheme.3 Securitization markets have remained more challenging, but several successful transactions indicate the potential for debt instruments that meet investor expectations in terms of transparency and risk mitigation. Over the past year, banks have also increased the share of deposit funding. Their dependence on volatile short-term funding sources has simultaneously diminished somewhat.

uA01fig15

Spread of Three-Month Unsecured Interbank Rate Over Three-Month Expected Policy Rate

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Bloomberg; and IMF staff calculations.

13. Nonetheless, challenges remain. UK banks will need to rollover or replace large amounts of wholesale funding coming due over the next few years, including funds received through government support schemes that are being phased out. At the same time, uncertainty about the sustainability of bank profits and the quality of bank assets remains significant. Notable risks include the commercial real estate portfolios of some banks. A large share of loans is due to be refinanced in the next few years, and default rates could increase. Another source of risks is consumer credit, which could cause higher losses if unemployment were to rise beyond current rates. Faced with such uncertainties and the prospect of tighter regulatory standards, banks have generally stayed cautious about extending new credit.

uA01fig16

Bond Redemption Profile for Major UK Banks

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Bloomberg; and IMF staff calculations.

14. Corporate credit standards have started easing, but banks’ loan portfolio has continued to shrink (Figure 9). Recent Credit Conditions Surveys indicate some increase in the availability of corporate credit, although lending standards still remain tighter than before the crisis. Moreover, there is a clear distinction by borrower size, with smaller companies continuing to face more restrictive credit supply. Trends in lending spreads confirm this divergence: loan rates for large borrowers have eased, while those for smaller borrowers have remained elevated. However, weak bank lending to corporates over the past year has reflected not only tight supply, but—perhaps more importantly—weak demand for investment finance. In addition, larger corporations have continued to raise net finance in capital markets, while reducing bank debt.

Figure 9.
Figure 9.

Credit Market Developments

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Bank of England; UK Statistics Authority; and IMF staff calculations.1/ Includes domestic loans and capital issuance in foreign currency.2/ All currencies.
uA01fig17

Corporate Sector: Credit Growth and Financing Constraints

(Percent)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; and IMF staff calculations.1/ Average of respective CBI survey responses related to output, investment, and (for manuf.) export orders.

15. Lending to households also remains weak. Mortgage lending has continued to grow throughout the downturn, albeit at a very modest rate. According to market intelligence, the number of mortgage products has increased over the last year, with the notable exception of high loan-to-value mortgages, which remain scarce, as many specialist lenders have exited from the market. Effective interest rates have declined, although spreads over the risk-free rate are well above pre-crisis levels. The supply of unsecured household credit is also significantly more restrictive than before the crisis, and spreads over reference rates remain very high. These tight lending conditions, together with households’ spending restraint and reduced credit-worthiness, have resulted in a gradual reduction of banks’ consumer loan portfolios.

uA01fig18

Variable Mortgage Rate vs. Policy Rate

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Bank of England; and IMF staff calculations.

UK Banking System: Selected Financial Soundness Indicators 1/

(End-of-period, percent)

article image
Source: UK authorities.

Domestically controlled banks on a cross-border, cross-sector consolidation basis.

Break in data series in 2006.

Net income after extraordinary items and taxes (period average).

III. Prospects, Risks, and Spillovers

16. The central scenario envisages economic recovery to continue at a moderate pace, as private and external demand progressively gather strength. Recent short-term indicators point to solid activity in the third quarter, even though a repeat of the strong second-quarter performance is unlikely. Inventory dynamics and a pick-up in fixed business investment are expected to remain the near-term drivers of growth. Order receipts also foreshadow higher exports, although the overall growth contribution from net trade is likely to be modest. Meanwhile, private consumption and residential investment are likely to be dampened by low real income growth, looming tax hikes, and still-strained balance sheets, but should strengthen gradually as labor market conditions improve. In this scenario, the household saving rate is projected to stabilize below its recent peak, but remain above pre-crisis levels. Taken together, the progressive strengthening of private and external demand would underpin a moderate-paced recovery, even as the public sector retrenches. Annual growth is projected at 1.7 percent this year and 2 percent in 2011.

17. Risks around this forecast are unusually large, though broadly balanced. Staff’s central projection reflects a range of factors, whose precise quantitative effects on growth are difficult to pin down. On the one hand, very low real interest rates, the past depreciation of sterling, and the ongoing recovery of global demand could give a greater boost to UK growth momentum. Indeed, the sharp drop in GDP during the crisis might suggest that the ensuing rebound should also be stronger than historical recoveries, not slightly weaker as projected by staff. On the other hand, the possibilities of further rapid deleveraging among households and banks, a sharp new downturn in the housing market, and greater-than-expected weakness in parts of the euro area constitute important downside risks to growth. Finally, the precise headwinds from fiscal consolidation are difficult to predict—they could turn out more powerful than expected or more modest as during the 1990s consolidation (see text chart). Overall, risks around the central forecast appear substantial, but broadly balanced. A particularly consequential, if unlikely, scenario would see major new shocks—arising from either external or domestic forces—derail confidence and thrust the UK economy into another extended recession. In this case, companies might begin large layoffs of staff they have retained so far, prompting a step increase in unemployment with highly adverse macro-financial feedback effects.

uA01fig19

There are also upside risks to staff’s growth forecasts, as the projected recovery would be slower than historical precedents…

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; NIESR; and IMF staff
uA01fig20

…with much more moderate growth than during the previous episode of fiscal consolidation in the UK

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: WEO; IMF staff calculations.1/ IMF staff projections.

18. A key underlying vulnerability relates to spillovers from external financial market shocks, given the global reach and connectedness of the UK financial sector. UK-owned banks have consolidated foreign assets exceeding 180 percent of GDP, despite some retrenchment over the last two years (Figure 10). Exposures are sizeable vis-à-vis the United States, where the commercial real estate sector remains an area of particular concern, and a number of advanced economies in Asia and Western Europe, including those EU members currently in the spotlight of financial markets. Specifically, claims on Greece, Ireland, Portugal, and Spain account for about 14 percent of GDP—a similar proportion as for French and German banks, although UK bank claims are more strongly concentrated on Ireland. Negative shocks in any of these markets could necessitate further write-downs and weaken UK banks’ capacity to support the domestic economic recovery with adequate credit supply. Additional spillovers could arise from the important role that foreign banks play in the UK, mostly via London’s wholesale financial services industry, but also in retail finance. Indeed, the tightening of credit supply since the beginning of the crisis partly owes to the sharp retrenchment of lending by some foreign banks. A simple VAR analysis confirms that global financial shocks have significant effects on the UK economy (Box 1).

Figure 10.
Figure 10.

External Claims of Consolidated UK-Owned MFIs 1/

(Billions of US$, unless indicated otherwise)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Source: Bank of England.1/ Ultimate risk basis.

19. Looking further ahead, there are also key uncertainties about the UK’s medium-term growth potential. In staffs assessment, the financial crisis has not only depressed aggregate demand, but also dented potential supply. As a result, spare capacity is far more limited than the drop in GDP would suggest, though probably still significant: using different empirical methodologies, staff estimates the current output gap on the order of 2-4 percent (see companion Selected Issues paper). Industry surveys, however, have started pointing to much-reduced slack within firms, notably in manufacturing (Figure 11). The significant uncertainty inherent in any estimates of current conditions extends to future potential growth. Overall, staff expects some lasting impact from the crisis, as potential growth is weighed down by higher risk premia, skill losses due to longer-term unemployment, and, perhaps, some permanent shift of demand away from sectors that enjoyed high productivity growth.

Figure 11.
Figure 11.

Indicators of Capacity Utilization

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; and IMF staff calculations.1/ Before January 2005: based on companies’ current situation, rather than being forward-looking.2/ Based on a range of survey indicators (provided by Bank of England, British Chambers of Commerce, Confederation of British Industry, and Eurostat, respectively) for capacity constraints and recruitment difficulties; normalized to average zero over the cycle, with unit standard deviation. Vertical bars in chart mark structural breaks in series due to inclusion of new indicators.
uA01fig21

Output Gap Estimates

(Percent of potential GDP)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: IMF staff estimates.

Inward Spillovers to the UK

Like most other major European countries, the UK has important financial sector links to stressed markets, such as the euro area periphery (Figure 10).4 UK banks’ consolidated claims on EA-4 countries (Greece, Ireland, Portugal, Spain) stand at about 14 percent of UK GDP. UK banks are also indirectly exposed to the EA-4, for example through claims on French and German banks (around 8 percent of GDP), which in turn have significant exposure to EA-4 countries. Separately, Ireland-owned banks operating in the UK account for 7 percent of domestic corporate loans and 3 percent of household loans. Further financial stress in the EA-4 countries could thus have noticeable effects on the UK economy.

The UK’s position as a global financial center is another important international spillover channel. A significant downturn in global financial markets—irrespective of the specific origin or trigger—could weaken UK banks’ capital base through reduced revenue from trading and investment banking activities, mark-to-market losses on financial assets, and possibly higher funding costs.

A structural VAR analysis points to large spillovers from shocks to global growth and financial market conditions to the UK economy. The VAR model comprises the following variables: UK real GDP, a weighted average of real GDP for countries to which UK banks have large exposures, a weighted average of the TED spread for the same countries, and the TED spread for the UK. The following identifying assumptions are imposed: UK variables do not affect variables for other countries; variables for other countries have contemporaneous effects on UK variables; and, within each “block” (i.e., a block of UK variables or other countries’ variables), real GDP has a contemporaneous effect on the TED spread, but not vice-versa. The analysis suggests that a structural shock that causes an average 100 basis-point increase in the foreign TED spread results in a 0.4 percentage point decline in the UK’s real GDP growth on impact, with the effect widening to 1.2 percentage points over the following two quarters before tapering off. The estimated effect of a structural shock on other countries’ GDP is also sizeable: a 1 percentage point decline in other countries’ real GDP results in about a 0.8 percentage point decline in the UK’s real GDP on impact, and the effect persists for several quarters. Although the model is somewhat mechanical and does not capture all variables and salient features of cross-border spillovers, the analysis suggests significant inward spillovers to the UK economy.

uA01fig22

Effect of 100 bp Shock to Other Countries’ TED Spread on UK Growth

(Percentage points)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

uA01fig23

Effect of 1 Percent Negative Growth Shock to Other Countries’ on UK Growth

(Percentage points)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

20. Against this backdrop, growth is projected to rise gradually to 2½ percent in the medium term, only slowly closing the output gap. This projection, and the risks around it, reflect many of the same factors that also impinge on the near-term outlook:

  • In general, fiscal consolidation could over time have more favorable growth effects, notably if consolidation boosts national saving or if a shift in activity from the public to the private sector raises productivity. However, to the extent that fiscal retrenchment weakens aggregate demand over a period that is more extended than envisaged in the central scenario, the resulting resource slack could also lead to some further scrapping of idle capital and persistent unemployment, reducing both actual and potential output.

  • The ultimate growth effect of a weaker exchange rate is equally uncertain. Staff expects domestic firms to gradually shift more production toward export and import-competing sectors in order to benefit from improved competitiveness. Yet, it is also possible that net exports prove to be relatively price-inelastic. In addition, global demand might have shifted away from some of the products and services in which the UK specializes. Compounding this uncertainty, there is a risk that sterling might rebound in the period ahead, as credible fiscal consolidation boosts confidence and strengthens the relative attractiveness of UK assets.

  • Lastly, there is considerable uncertainty over the future supply and price of credit to businesses, given the extent of regulatory and financial pressures bearing on banks. Although weak net lending may not hurt the recovery at an early stage, financing constraints could become more onerous as demand picks up over the medium run.5

Authorities’ views

21. The authorities’ envisaged somewhat higher growth than projected by staff. There was essentially no difference in the outlook for 2010 (the OBR’s lower growth forecast in the June budget was made before the strong Q2 outturn was released), but both the OBR and BoE projected somewhat stronger growth than staff in 2011 and the medium term (text chart and Table 2). The authorities’ stronger growth projections are underpinned by:

  • a larger contribution from net exports, driven by a stronger supply-side response to past sterling depreciation; the authorities viewed the weak contribution from net exports so far as partly reflecting temporary factors, such as high imports due to car scrappage schemes and restocking; and

  • stronger fixed investment as corporates respond to a better demand outlook and planned reductions in the corporate tax rate.

Table 1.

United Kingdom: Selected Economic and Social Indicators, 2005-11

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

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.

2010: actual data as of August.

2010: actual data through September.

Average. An increase denotes an appreciation.

2010: actual data through July.

Based on consumer price data.

Table 2.

United Kingdom: Public Sector Operations, 2008/09-15/16 1/

(Percent of GDP)

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Sources: Office for National Statistics (ONS), HM Treasury, and staff estimates.

Historical data include the temporary effects of financial interventions.

Including depreciation.

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

From 2010/11 onwards, Budget projections for general government gross debt are on a Maastricht basis.

Staff projections based on Budget June 2010 expenditure plans and staff’s growth assumptions for revenue projections and cyclical adjustment.

Nonetheless, the authorities acknowledged both upside and downside risks to their central scenario, reflecting similar factors and concerns noted above by staff. At the international level, the authorities stressed that the effectiveness of their policy efforts will be amplified if they are complemented by coordinated multilateral action to rebalance global demand toward more sustainable external positions across countries and to strengthen financial regulation.

uA01fig24

Comparison of Real GDP Growth Projections

(Percent)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: as shown above.1/ Calendar-yeargrowth rate computed as average of 4-quarter growth rates (mean forecast at market interest rates).

IV. Ensuring Fiscal Sustainability

22. The June budget sets out an ambitious and comprehensive medium-term fiscal consolidation plan. The government has set itself a fiscal mandate to balance the cyclically-adjusted current budget by the end of a five-year rolling horizon—currently by 2015/16—and put the net debt-to-GDP ratio on a declining path by 2015/16. Announced policy plans have been drawn to meet these goals one year early, thus providing some margin. Correspondingly, the overall fiscal deficit is programmed to fall to 2 percent of GDP by 2014/15, from 11 percent of GDP in 2009/10. This represents an additional tightening of about 2 percentage points relative to the previous government’s plans, bringing the total planned structural adjustment to 8 percent of GDP in the five years to 2014/15. The projected adjustment is relatively frontloaded, with discretionary tightening of 1¼ percentage points in 2010/11 and 2½ percentage points in 2011/12.

uA01fig25

Discretionary Consolidation Plans and Government Debt

(percent of GDP)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Source: HM Treasury.

23. Although this consolidation effort involves painful decisions and dampens short-run growth, it is necessary to enhance credibility and ensure fiscal sustainability. The government has rightly emphasized the priority of ensuring debt sustainability to avoid the tail risk of a very costly loss of confidence in the sovereign and to regain fiscal space to cope with future adverse shocks and demographic-related spending pressures (Box 2). Under the announced policy plans, it should be feasible to lower the debt-to-GDP ratio to 60 percent by 2025, whereas returning to pre-crisis debt levels (40 percent of GDP) would require additional fiscal effort after 2015 (see the debt sustainability analysis in Annex A for a discussion of the required fiscal adjustment to lower the debt-to-GDP ratio). As such, the consolidation plan should help meet the government’s central objectives of preserving confidence in the UK’s public finances and promoting a gradual rebalancing of the economy away from excessive public deficits toward private sector-led growth. In this context, the decision to frontload the adjustment has helped further dispel market concerns, especially against the backdrop of heightened fiscal stress in parts of the euro area. Decisive policy implementation will contribute to keep a favorable financing environment with low risk premia and might help to mitigate the effects of fiscal tightening on growth.

To Tighten, or Not to Tighten—UK Fiscal Policy in the Public Debate

Despite consensus on the need for medium-term fiscal consolidation, a debate has emerged over the appropriate timing of UK budget cuts. Pre-election policy proposals by all major parties agreed on the priority of deficit reduction. Indeed, the March 2010 budget of the previous government and the June 2010 budget of the new coalition both feature significant fiscal tightening from 2010 onward—differences in the envisaged fiscal effort do not exceed ½ percent of GDP in any year. Nonetheless, the right timing of consolidation has become the subject of a controversial debate, reflecting different views about the economic outlook and key risks.

Critics of immediate fiscal tightening have stressed the risk of choking off a still-fragile recovery. The main arguments are as follows: 6

  • There is no guarantee that other sectors will continue expanding while the government retrenches. Additional monetary stimulus may not be powerful enough to offset this risk.

  • Beyond the adverse effect on demand, excessive tightening may even destroy supply capacity. In this view, a bleak assessment of the UK’s structural deficit could be self-fulfilling: because policymakers assume a large permanent drop in potential output, they tighten policies too early; this causes capital scrapping and human capital losses that a faster recovery would help prevent.

  • The need to placate bond markets is overstated. Long-term UK interest rates show no sign of market panic, and commitments to future fiscal consolidation are more important than immediate cuts. In this context, tying consolidation plans to the political cycle imposes unnecessary pain: “A parliamentary term is a political reality, not an economic one.”

Many of these points have merit, but there are strong counterarguments as well:

  • Although fiscal tightening has already started, there are signs of economic recovery led by the private sector. Indeed, the consensus forecast is for solid growth next year, partly reflecting natural cyclical momentum. Moreover, the combination with very loose monetary policy should support the necessary rebalancing of demand, including through higher net exports.

  • Spare capacity is notoriously difficult to assess in real time, but the available evidence points to an output gap not far from the estimate underlying the June budget. And while there is a risk to underestimating potential, there is also the opposite risk—of belatedly discovering higher-than-expected structural deficits and greater inflationary pressure. Furthermore, experience from historical financial crises consistently points to a lasting and large drop in potential GDP. Is this time really different?

  • A glance at current bond yields does not do justice to the risk of a sovereign funding crisis—a low-probability, but very-high-impact scenario for the UK. To begin with, gilt yields have been depressed by large-scale BoE purchases ( see Box 3). More importantly, market assessments can change quickly, as witnessed by the surge in borrowing costs in some Eurozone countries. Indeed, UK spreads also rose in the first few months of this year, but started moving the other way in May/June, not least in response to the budget announcements (chart, p. 32).

  • In this context, the critics downplay the importance of political credibility: promises of future consolidation alone are unlikely to be persuasive, especially once they reach beyond the current term of parliament. The novelty of a coalition government may further heighten this concern.

After weighing these different arguments and assessing the outlook and risks, staffs view is that a significant fiscal tightening with frontloading in 2011/12 is appropriate to secure confidence in the UK’s debt sustainability. However, the uncertainty surrounding the current cyclical outlook puts a premium on contingency planning. Thus, the authorities need to be prepared to tackle surprises on either side of their central forecast.

24. The budget contains an appropriate mix of concrete spending and revenue measures, lending credibility to the government’s consolidation plan. Although the brunt of the adjustment comes from reductions in public expenditure, the budget also programs several tax measures, including a rise in the standard VAT rate from 17½ percent to 20 percent from January 2011, a hike in capital gains tax from 18 percent to 28 percent, and a small bank levy on selected wholesale liabilities. Corporate income tax, by contrast, will be lowered gradually to support growth during the adjustment period, and the personal income tax allowance will be raised. Expenditure measures, in turn, include a two-year pay freeze for most public sector employees and reductions in social benefits. Overall, the new budget identifies about half of the required discretionary spending cuts. Further details on spending plans by government function will be provided in the October 2010 Spending Review (a supplement to this staff report will provide information on the outcome of this review). The focus on spending measures is appropriate in light of the significant run-up in spending over the last decade and international experience showing that expenditure-based consolidations lead to longer-lasting budgetary improvements (see companion Selected Issues paper).

uA01fig26

Discretionary Consolidation between 2009/10 and 2014/15

(Total announced:£128 billion)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: HM Treasury, and staff estimates.
uA01fig27

General Government Expenditure

(percent of potential GDP)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Source: IMF staff estimates.

25. The October Spending Review provides an opportunity to strengthen the composition of adjustment. Total managed expenditure (TME) is set to decline by 7.7 percentage points of GDP over the next six years to 2015/16. Despite announced reductions in social benefits, annual managed expenditure (AME; the nondiscretionary component of spending) will contribute just 0.1 percentage points to the adjustment, as debt interest payments are projected to rise. The bulk of the adjustment falls, therefore, on departmental expenditure limits (DEL; the discretionary component). All government functions, except for health and foreign aid, are projected to face real cuts of 25 percent on average over the next four years. Public investment would be especially affected, falling by one-third in real terms. Implementation of such cuts could prove challenging. Against this background, staff recommends putting greater emphasis on reducing public sector compensation premia and achieving savings in benefits and transfers through better targeting.7 This would help avoid an excessive squeeze on investment and other non-protected government functions, help mitigate the growth effects of adjustment (because reducing transfers to the less needy may have a smaller effect on consumption), and help shield the vulnerable.

uA01fig28

Contribution to the Change in Total Managed Expenditures, 2009/10 - 2015/16

(in percent of GDP)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

26. The authorities’ fiscal consolidation strategy may be tested in the event risks to growth materialize. Under staff’s central scenario, fiscal tightening is expected to dampen growth, though without stopping the ongoing recovery. This view is consistent with the OBR’s assumption of positive, but moderate, fiscal multipliers and the frontloading of measures with the smallest multipliers (e.g., VAT hike). However, consolidation plans could be tested if risks to growth materialize on either the downside (raising calls for stimulus) or the upside (increasing cyclical revenue and reducing the perceived need for structural adjustment). In either case, spending cuts should generally proceed on schedule to maintain the consolidation effort’s credibility and avoid inserting undesirable volatility into multi-year expenditure plans. Automatic stabilizers should be allowed to operate freely in both directions to preserve the targeted structural adjustment and help stabilize the economy—supporting growth if downside risks materialize and supporting disinflation if upside risks materialize. In the unexpected but possible case of a significant and prolonged downturn, alongside further support from monetary policy, temporary tax cuts should also be considered. Such tax cuts are faster to implement and more credibly temporary than expenditure shifts and should be targeted to low-income households, employment creation, or investment to increase their multipliers. Simultaneous adoption of entitlement reforms (see below) would be desirable to safeguard fiscal sustainability and market credibility.

OBR Assumptions on Fiscal Multipliers

article image
Source: OBR.

Public Sector Finances

(percent of GDP) 1/

article image
Sources: Office of National Statistics, HM Treasury, and staff estimates.

Fiscal year starts in April and ends in March.

Negative of the change in cyclically adjusted balance.

27. Entitlement reforms to address long-term fiscal challenges should be pursued. Although the UK’s demographic outlook compares favorably with that of other advanced economies, staff estimates that age-related spending will increase by about 4 percentage points of GDP over the next 20 years under current policies. More than three quarters of this increase is due to higher health and long-term care spending, which highlights the importance of healthcare cost containment and efficiency reforms. On pensions, measures to reduce costs include accelerating the planned increases in the statutory retirement age for state pensions and gradually aligning the generosity of public pensions with their counterparts in the private sector.8 These reforms would have at most a minor immediate impact on aggregate demand, but would have long-term effects on fiscal sustainability, thus bolstering the credibility gains of the government’s adjustment package. The initiatives launched by the government to review reform options for state and public sector pensions are therefore welcome.

28. The establishment of a new independent Office for Budget Responsibility is a welcome step toward strengthening the budget process. Tasks envisaged for the OBR include to provide the macroeconomic and fiscal forecasts for the budget and to assess fiscal sustainability and compliance with the fiscal mandate. The June budget was, for the first time, based on such independent forecasts issued by the interim OBR. The new office should help enhance the transparency and credibility of the budget process and better inform policy decisions (though unbiased forecasts do not by themselves ensure fiscal discipline). As the role and remit of the permanent OBR are finalized, it will be important to incorporate lessons from international best practice. Specifically, the OBR must be fully independent and perceived to be so. To this end, it will be important to ensure an arms-length relationship with Treasury, full-access rights to pertinent information, multi-year budgets, adequate staffing, and a sufficiently broad remit to allow the OBR to achieve its objectives.

29. The UK’s fiscal institutions would further benefit from the eventual adoption of a new rule-based framework. Although the current fiscal mandate is appropriate to guide the consolidation process, in due course it should be replaced with more permanent fiscal rules. The credibility of a fiscal rule would be supported by input from the OBR. Fiscal rules, such as a structural balance rule or a rule that responds to deviations in output growth relative to trend growth, rather than changes in the output gap, could work well in the UK (see companion Selected Issues paper). Notably, such rules would anchor medium-term debt sustainability, provide clear operational guidance for fiscal policy, ensure transparency and ease of monitoring, and promote countercyclical policies.

Authorities’ views

30. The authorities stressed that frontloaded adjustment was necessary to bolster credibility. With sovereign solvency concerns mounting in many parts of Europe and gilt spreads over German bunds rising in the first half of 2010, the authorities viewed frontloading as imperative to demonstrate strong commitment to fiscal consolidation and differentiate the UK from other fiscally troubled countries. Because spending is difficult to turn around quickly, the frontloading requires some near-term tax increases, though the bulk of the multi-year consolidation comes from spending cuts, in line with international evidence on successful consolidations. The authorities acknowledged risks to their baseline scenario and agreed with staff that automatic stabilizers provide an important safeguard against shocks. On strengthening the quality of adjustment and entitlement reform, the authorities saw merit in many of staff’s recommendations and noted that decisions in these areas would be made in the upcoming spending and pension reviews. On fiscal institutions, the authorities emphasized the importance of the new OBR as a critical improvement aimed at addressing deficiencies in the previous fiscal framework. The authorities also agreed that the current fiscal mandate is designed to address the exceptional fiscal challenge and have set out their intention to tighten the mandate (by shortening its horizon) once public finances are closer to balance.

uA01fig29

Government Bond Spreads Relative to 10-Year Bund Yield

(Percentage points)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; and IMF staff calculations.1/EU-4: Greece, Ireland, Portugal, and Spain (simple average).

V. Maintaining Monetary Stimulus

31. Unprecedented monetary easing has helped restore confidence and bolster the recovery. With fiscal policy constrained by the need to ensure sustainability, policy rates at the lower bound, and their effect tempered by high bank lending spreads, the BoE has provided significant additional stimulus through large-scale asset purchases. In total, the central bank bought nearly £200 billion in medium- and longer-term gilts between March 2009 and January 2010, along with small amounts of commercial paper and corporate bonds. Although the precise impact on aggregate demand remains hard to quantify, there is clear evidence that quantitative easing has depressed bond yields and boosted asset prices, thereby shoring up market confidence, household net wealth, and corporate credit supply (see Box 3). Meanwhile, the prudent setup of the Asset Purchase Facility—with full ex-ante indemnity from the Treasury—has preserved trust in the BoE’s operational independence.

32. Yet, inflation over the last year has continued to surprise on the upside (Figure 12). From a trough at just above 1 percent in September 2009, CPI inflation rose to 3½ percent by early 2010 and has remained elevated since. Much of the rise in the CPI can be attributed to the rebound of commodity prices and the January 2010 hike in the VAT rate. However, the continued overshooting relative to earlier inflation forecasts points to additional price pressures that have set the UK apart from its advanced country peers:

Figure 12.
Figure 12.

Price Developments

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Bank of England; UK Statistical Office; and IMF, Commodities Database.1/ Core CPI excludes energy, food, alcohol, and tobacco.2/ Retail Price Index; contains cost of housing.3/ Computed as quarterly average of difference between nominal and real (RPI-linked) forward gilt yields. Estimates likely to be biased upward by the presence of an inflation risk premium, and downward by the liquidity risk premium on real gilts.
uA01fig30

Monthly UK CPI Change: Deviation of Outturn from Median Bloomberg Forecast

(Percentage points)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Bloomberg; and IMF staff calculations.
  • A leading explanation is greater-than-expected pass-through from past sterling depreciation (see Box 4). Indeed, allowing for pass-through on the order of 0.15-0.2 explains most of the cross-country dispersion in inflation outcomes over the last three years. More disaggregated CPI data support this argument, as much of the inflation dynamics since mid-2007 reflect a striking surge in goods prices, which have a comparatively large import component.

  • A complementary explanation relates to the effect of spare capacity on inflation. Although most indicators, notably unemployment and wage growth, point to continued slack in the economy, corporate profit margins have proven atypically resilient during the latest downturn—and not only among exporters, who have benefited from the weaker currency. To some extent this suggests more limited spare capacity than previously thought. Yet, firms’ unusual pricing behavior might also reflect the particular influence of tight credit. Indeed, surveys show that many firms have sought to avoid price cuts in order to preserve cash flow, implying a relatively low short-term elasticity of demand. This particular influence is likely to wane as credit concerns ease and competition for market share revives.

Arguably as a result of the recent above-target outturns, short-term inflation expectations have edged up, whereas medium-term inflation expectations generally appear to remain well-anchored.

uA01fig31

UK: Medium-Term Inflation Expectations

(Percent)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: YouGov; Consensus Economics; HM Treasury; Bloomberg; and IMF staff calculations.
uA01fig32

Recent Inflation Trends and Near-Term Outlook

(Percent)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Haver; and IMF staff projections.

Effectiveness of the Bank of England’s Quantitative Easing

Between March 2009 and January 2010, the BoE bought nearly £200 bn in medium- to long-term gilts, financed by issuing reserve money. These purchases amount to 14 percent of UK GDP, 25 percent of outstanding gilts, and 40 percent of gilts in the relevant market segment (at end-2009).

Event-study analysis suggests that the purchases have depressed yields by up to 125 basis points. Judging from a two-day event window around key announcement dates, the gilt yield curve has shifted downward by between 20 and 125 basis points, with the largest drop for long maturities. Using a one-day window, the effects are only half as large, but still significant.9 The strongest yield response is found for March 5, 2009, when the first set of purchases was announced. Moreover, most of the decline in yields appears to reflect portfolio balance effects caused by a lower net supply of gilts. OIS rates, which would capture market expectations about future interest rate policy, fell by a small amount only.

uA01fig33

Cumulative Shift in Gilt Yield Curve around Key QE Announcement Dates 1/

(Basis points)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

uA01fig34

Decomposition of Cumulative Change in 10-Year Gilt Yield 2/

(Basis points)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Bank of England; and IMF staff calculations.1/ Based on one-or two-day event windows around six key announcement dates, i.e., Feb. 11, 2009; March 5, 2009; May 7, 2009; Aug. 6, 2009; Nov. 5, 2009; and Feb. 4, 2010.2/ Based on two-day event windows around key dates.

Lower long-term interest rates have supported the broader recovery in financial markets since March 2009. A clear-cut causal link from QE to the drawn-out recoveries in equity, corporate bond, and other financial markets is impossible to establish, given the many other influences at work. Yet, it is striking that the launch of QE in the UK—along with similar announcements in the US—coincided with the turn-around in UK and global equities. A positive spill-over from lower long-term yields is also consistent with evidence on the effectiveness of the Fed’s asset purchases; see FRBNY Staff Report No. 441.

uA01fig35

Quantitative Easing and UK Equity Prices

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Source: Haver

As such, QE has boosted confidence, created positive wealth effects, and improved the supply of credit to corporates. The latter effect arose both directly, through small-scale BoE purchases of commercial paper and corporate bonds, and indirectly, as large-scale gilt purchases induced investors to shift funds into other assets, including corporate bonds. Together, these developments have bolstered the recovery, even if the ultimate impact of QE on demand and inflation remains difficult to quantify.

Accounting for Recent UK Inflation Dynamics

UK inflation has consistently exceeded expectations since the beginning of the financial crisis. Although growth has fallen short of BoE projections, inflation has surprised on the upside, even relative to near-term forecasts. Tax policy is partly responsible for relatively high inflation outturns, but arguably cannot account for the observed upside surprises: the January 2010 VAT hike was preannounced and is estimated to have added about ¾ of a percentage point to the CPI, in line with prior expectations. Higher commodity prices, in turn, explain some of the forecast error, but still leave open why UK inflation has markedly exceeded that of other advanced economies.

uA01fig36

Deviation of GDP and CPI Outturns from 2-Quarter-Ahead BoE Projections since the Beginning of the Financial Crisis 1/

(Percentage points)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Bank of England Inflation Reports; Haver; and IMF staff calculations1/ Projections for 2009Q2 as reported in the November 2008 Inflation Report (mode forecast under market interest rate expectations), and so forth.

A leading explanation for the inflation surprises is greater-than-expected pass-through from past sterling depreciation. Recent research has generally documented low and declining exchange rate pass-through in advanced economies. Based on this evidence, and the experience of large sterling depreciation in the early 1990s that triggered no apparent rise in domestic prices, many forecasters appear to have assumed little impact from recent sterling weakness. Yet, this notion seems at odds with a simple cross-country chart comparing exchange rate developments and cumulative CPI inflation since mid-2007. Indeed, much of the variation in inflation across countries could be readily explained by pass-through on the order of 0.17—a high, but not implausible value, especially when the exchange rate shock is large and widely expected to be permanent.10

uA01fig37

Cumulative CPI Inflation vs. Change in Nominal Effective Exchange Rate, July 2007- July 2010

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A001

Sources: Eurostat, Haver, IMF-INS, and IMF staff calculations.

This explanation is also consistent with cross-sectional evidence. Relative to euro area inflation since mid-2007, UK inflation has been highest for some elements of the CPI basket that are likely to be very sensitive to exchange rate changes, such as gas and fuels, household appliances, and package holidays. By contrast, inflation has been relatively moderate for accommodation services, rent, and out-patient services.

33. Underlying price pressures are expected to be moderate in the period ahead, but another looming VAT hike will keep inflation above 2 percent throughout 2011. As the effects of past price level shocks fade, inflation should continue to ease gradually. However, the announced rise in the VAT rate in January 2011 is set to raise the CPI by another 1-1½ percentage points.11 Staff therefore projects inflation to remain above 2 percent throughout 2011, although this masks the lingering downward pressure from spare capacity. Indeed, most other pending fiscal measures, notably the two-year freeze of most public sector salaries, will have a moderating effect on underlying inflation. Barring new shocks, this effect should become apparent in headline inflation falling below target by early 2012.

34. Risks around the central inflation projection are significant, but broadly balanced. Historical episodes of persistent large output gaps suggest that disinflationary pressures should ultimately take hold (see companion Selected Issues paper), but there is considerable uncertainty about the strength of this effect. On the one hand, economic slack and low wage growth could pull down inflation faster in the period ahead, especially if corporate margins were to ease further. On the other hand, spare capacity might turn out to be more limited or less potent than currently assessed. In this context, an extended series of above-target inflation outturns entails the risk that rising inflation expectations might start to feed back into wage and price-setting. In addition to these sources of uncertainty, the inflation outlook is subject to the risk of further fluctuations in commodity prices and the exchange rate.

35. A highly accommodative monetary stance remains appropriate for now, but the Monetary Policy Committee (MPC) will have to be nimble in responding to new developments. The current stance reflects the need to maintain overall policy stimulus, as economic activity remains below potential, fiscal policy is set to tighten sharply, and financial intermediation normalizes only gradually. Near-term adjustments to the monetary stance should be guided by incoming data. Developments in effective labor costs, other input prices, and inflation expectations bear particularly close monitoring in this regard:

  • If a stalling recovery were to heighten disinflationary forces, quantitative easing should be expanded. In the first instance, a resumption of gilt purchases represents a natural policy option. The marginal effect of additional purchases is uncertain, but some further flattening of the yield curve clearly seems achievable. If necessary, the authorities should also consider the case for buying larger amounts of private sector assets, chosen to target specific market dysfunctions or valuation anomalies that might emerge in a renewed sharp downturn. However, such purchases may best be framed as a fiscal operation—financed by the issuance of gilts, which the BoE could separately decide to buy—to ensure proper accountability for the resulting financial and political risk. More generally, decisions on further quantitative easing need to bear in mind their effect on the risk profile of the consolidated public sector balance sheet, as they involve issuing a short-term liability (bank reserves) in exchange for extinguishing a long-term liability (gilts) or acquiring a risky private-sector asset.

  • Conversely, the MPC must stand ready to start a gradual tightening if incoming data raise the prospect of above-target inflation over the policy horizon. In this case, the MPC intends to give standard Bank Rate increases priority over asset sales. Staff concurs with this strategy, as changes in policy rates—the central bank’s standard and proven tool—are easiest to fine-tune and best understood in terms of their effects. Importantly, there is no reason to suspect that the expanded stock of base money will compromise effective monetary control, given that reserves are fully remunerated. Asset sales can, therefore, be programmed to occur at a pace that does not interfere with stable gilt market conditions.

Authorities’ views

36. The authorities generally agreed with staff’s views on the inflation outlook and monetary stance, but opinions on the MPC have recently become more divided. The majority of MPC members viewed the current policy stance as appropriate and favored a data-dependent approach to next steps. For one MPC member, the balance of risks was such that it was appropriate to start to withdraw some of the exceptional monetary stimulus provided by the easing in policy in late 2008 and 2009. Another MPC member made the case for expanding the asset purchase program so as to engineer a faster recovery, lest inflation fall below target in the medium term. MPC members also differed on the likely effectiveness of further gilt purchases—some could see arguments for “diminishing returns” from an additional round of quantitative easing, while others were more optimistic.

VI. Strengthening the Financial System

A. Financial Sector Soundness and Public Support

37. Banking sector health has improved, but continued progress is needed to enhance resilience and reduce risks to the economy and the taxpayer. To these ends:

  • Banks’ capital buffers should be strengthened further over time to prepare for tighter regulatory requirements in the future, taking into account bank-specific circumstances. Continued restraint on dividends and remuneration will be critical in this regard. Although higher capitalization will decrease expected returns on equity, this should be compensated by lower risks for bank stakeholders and society at large. Larger capital buffers will also enhance banks’ ability to raise longer-term funds at reasonable costs and maintain adequate credit supply to the private sector at all times.

  • Public funding support should be unwound in line with initial program design to gradually reduce taxpayer risk and restore private sector responsibility. The crisis exposed UK banks’ excessive reliance on unstable funding sources. Extensive public support has provided temporary relief. However, the key facilities—the Special Liquidity Scheme and the Credit Guarantee Scheme, which originally accounted for a combined £320 billion in support—are set to wind down gradually in the coming years. Against this backdrop, supervisors need to keep up the pressure on banks to develop robust new funding models based upon a sound mix of simpler and more transparent instruments. Progress in this direction would benefit from timely clarification of how international and EU regulators will treat different capital and funding instruments in the future.

  • The case for deeper structural changes to the UK financial sector needs to be examined. Thus, the public debate on possible reforms, informed by the government-appointed Independent Commission on Banking, which is to present a final report by September 2011, is welcome.12 These issues, along with broader questions of systemic stability, will also be taken up in a comprehensive assessment to be conducted by staff in 2011, under the IMF’s “Financial Sector Assessment Program”(FSAP).

B. Regulatory Reform

38. The authorities should continue to work toward an ambitious international package of regulatory reform and rigorous implementation of this package in the EU. The UK has played a constructive role in the global regulatory debate, with innovative proposals in many policy areas, pioneering work on recovery and resolution plans (RRPs), and a blueprint set of new liquidity rules (see companion Selected Issues paper). The authorities should continue to provide intellectual leadership, while cooperating closely with their international partners to secure agreement on a suitable set of reforms. Building on the recent Basel III and Financial Stability Board proposals, the following priorities stand out:

  • The UK is home to a number of very large financial institutions. Thus, the authorities have rightly emphasized the need for concrete tools, such as capital and liquidity surcharges, to address the resulting systemic risk.

  • In the same vein, greater international cooperation is needed to facilitate the resolution of complex, cross-border financial institutions, as envisaged under the authorities’ pilot exercise on RRPs. The UK’s 2009 Banking Act has provided an effective national special resolution regime for banks.13 However, greater international cooperation is indispensable to develop credible policy tools for handling the failure of systemically important entities with complex, cross-border activities. In this context, the UK authorities should support the EU’s ongoing efforts to enhance the framework for cross-border supervision and resolution.

39. The development of macroprudential instruments to mitigate the amplitude of credit cycles is another key policy priority. Under the new prudential architecture, the government will create a Financial Policy Committee (FPC) in the BoE with an explicit mandate for macroprudential oversight, thus addressing a critical gap in the previous framework. To perform its task, the FPC will require a well-defined financial stability objective and adequate tools—such as variation in capital risk weights on specific asset classes and in prudential standards, including limits on loan-to-value ratios. The authorities have published a set of proposals along these lines, but many details remain to be settled. Calibrating and communicating the FPC’s policy decisions will represent a particular challenge, as little is known about their quantitative impact and interaction with monetary policy. Moreover, some measures will need to be coordinated with foreign regulators, especially within the EU, to be effective. The new European Systemic Risk Board provides a useful forum for such coordination.

C. Moving to a New Regulatory Architecture

40. Continued emphasis on proactive microprudential oversight is critical as the UK moves to a new regulatory architecture. The government has decided to abolish the tripartite system and charge the BoE—via a new subsidiary, the Prudential Regulation Authority (PRA)—with the prudential regulation of deposit-taking institutions, investment banks, and insurance companies. A separate new entity, the Consumer Protection and Markets Authority, will be charged with ensuring consumer protection as well as regulation of financial markets. Although this new setup should facilitate the integration of micro- and macroprudential oversight, institutional changes alone are no guarantee for superior outcomes, and any reorganization of this scale poses operational risks. It will thus be crucial to carefully manage the transition while continuing to enhance the more intrusive, proactive, and strategic approach to supervision adopted since the crisis.14. In this context:

  • In order to enhance consolidated supervisions, the PRA should have the authority to directly supervise and, if necessary, give formal directions at the financial holding company level.

  • Adoption of a “prompt corrective action” regime would further strengthen the supervisor’s capacity to address emerging risks at an early stage.15

  • Prudential oversight should be supported by market discipline. A useful tool in this regard would be the regular public disclosure by the supervisor of non-confidential firm-level prudential returns.

  • The tightening of banking sector regulation might cause risks to migrate into less regulated parts of the financial system. A key task for the FPC, therefore, will be to identify such risk migration and ensure a commensurate widening of the regulatory perimeter.

Authorities’ views

41. There was agreement on the reform agenda, although specific outcomes will need to reflect international developments and domestic consultation processes. The authorities expressed broad satisfaction with the initial set of Basel III proposals, but stressed the need to make swift progress on outstanding items, notably a firming-up of liquidity standards and creation of robust tools to contain systemic risk. The UK’s policy line, in this regard, would be to push for ambitious reform, while seeking broad-based international agreement to limit scope for regulatory arbitrage. In terms of the domestic reform agenda, the government has laid out its priorities in a series of consultation papers and set up the Independent Commission on Banking, and now awaits the outcome of these processes. In this context, the authorities noted that they would consider staff’s specific proposals on enhancing supervision.

VII. Staff Appraisal

42. The UK economy is on the mend, but crisis-related scars still need healing. Economic recovery is underway, unemployment has stabilized, and financial sector health has improved. These developments reflect both a natural cyclical rebound and the authorities’ forceful policy actions, including large-scale financial-sector interventions, temporary fiscal stimulus, unprecedented monetary easing, and the announcement of a strong and credible multi-year fiscal consolidation strategy. The challenge going forward will be to support sustainable economic recovery as the policy focus shifts from crisis management to post-crisis repair. With the private sector running high financial surpluses and the public sector posting record-high deficits, sustainable growth requires a gradual rebalancing toward private and external sector-led demand.

43. Consistent with these objectives, the government’s fiscal consolidation plans have been instrumental in preserving confidence in debt sustainability. The plans are also necessary to regain fiscal space to cope with future shocks. The fiscal mandate of balancing the cyclically-adjusted current budget over a five-year rolling horizon—currently by 2015/16—is ambitious but feasible, and its credibility has been bolstered by frontloaded actions to achieve the mandate one year early. Market reaction has been positive, as the consolidation greatly reduces the risk of a costly funding crisis and supports rebalancing. These benefits outweigh expected costs in terms of adverse effects on near-term growth.

44. A highly accommodative monetary stance remains appropriate to offset the contractionary impulse from fiscal policy and keep inflation close to target over the policy horizon. Barring unforeseen shocks, inflation should revert to target over the policy horizon, as one-off price level shocks dissipate and disinflationary forces—existing spare capacity and public sector wage restraint—keep underlying price pressures in check. The BoE’s accommodative stance thus reflects the need to maintain overall policy stimulus as fiscal tightening takes hold and financial intermediation normalizes only gradually.

45. This policy mix should facilitate the necessary rebalancing while supporting a moderate-paced recovery. With interest rates low and spare capacity within firms falling, corporates are drawing on their strong financial positions to raise investment from its current low levels. Similarly, although households are likely to remain thriftier than before the crisis, they have begun to raise their consumption amid stabilizing labor markets and recovering asset prices. Over time, past sterling depreciation should also boost net exports as higher profit margins encourage expansion in import-competing and export sectors. This progressive strengthening of private and external demand should underpin a moderate-paced recovery, even as the public sector retrenches.

46. Risks to this central scenario are substantial and policies will need to adapt if they materialize. Downside risks include the continued fragility of confidence, still-strained balance sheets among households and banks, and possible resurgence of sovereign and banking market turmoil in the euro area markets. Further, headwinds from fiscal consolidation could turn out to be more powerful than expected. On the upside, expansionary impulses from very low real interest rates, past sterling depreciation, and the ongoing recovery of global demand could be greater than expected. This would boost the UK economy onto a faster-than-expected growth path, but could also entail stronger inflationary pressure. A key safeguard against these risks is the free operation of automatic fiscal stabilizers in both directions. In addition, monetary policy must remain nimble: asset purchases should resume if the recovery weakens and disinflationary pressures mount; conversely, policy rates should tighten gradually if output recovers apace and inflation continues to surprise on the upside. In the unexpected but possible case of a significant and prolonged downturn, temporary targeted tax cuts should also be considered (alongside further monetary easing), ideally combined with longer-term entitlement reforms to safeguard fiscal sustainability and market credibility.

47. The current spending and pension reviews provide an opportunity to further mitigate risks by strengthening the quality of fiscal adjustment. International evidence suggests that the planned emphasis on spending reduction increases the likelihood of a successful consolidation. Within the spending envelope, however, more weight should be given to reducing public sector compensation premia and achieving savings in benefits and transfers through better targeting. This would help shield the vulnerable, mitigate the growth effects of adjustment (as such cuts likely have smaller fiscal multipliers), and allow relatively more spending on infrastructure investments that could boost potential growth. Entitlement reforms, such as accelerating retirement age increases for state pensions and gradually aligning the generosity of public sector pensions with those in the private sector, would similarly bolster fiscal sustainability while having limited adverse effects on aggregate demand now. The initiatives launched by the government to review such reforms are therefore welcome.

48. The authorities should continue to fortify fiscal institutions, building on significant progress in this area. The establishment of a new independent OBR is an important and welcome step. Though not a substitute for strong commitment to fiscal discipline, the OBR should enhance the transparency and credibility of the budget process and help inform policy decisions. As the role and remit of the permanent OBR are finalized, its independence should be underpinned by sufficient legal authority and safeguards. In due course the current fiscal mandate—an appropriate guide for the consolidation period—should be replaced with a more permanent rule-based framework that would also be monitored by the OBR.

49. Efforts should continue to strengthen financial sector health and reduce related risks to the economy and taxpayer. Toward these ends:

  • Capital buffers should be raised further, notably by restraining dividend payouts and remuneration budgets, taking into account bank-specific circumstances.

  • Crisis-related public interventions should be unwound in line with initial program design to gradually reduce taxpayer risk and restore private sector responsibility. To help replace this support, supervisors should maintain pressure on banks to develop robust new funding models based on a broad mix of simpler and more transparent instruments.

  • The creation of an FPC with an explicit macroprudential mandate is welcome. To be effective, many macroprudential measures will need to be closely coordinated with regulators in other countries, notably within the EU. One critical task for the FPC will be to identify risk migration into less regulated parts of the financial system and ensure a commensurate widening of the regulatory perimeter.

  • The transition toward a new prudential architecture needs to be managed carefully to mitigate operational risks. At the same time, the authorities should continue enhancing the more intrusive, judgment-based, and strategic approach to supervision adopted since the crisis. To assist this objective, it would be useful to: (i) provide the PRA with authority to supervise and, if necessary, give formal directions at the financial holding company level in order to enhance consolidated supervision; (ii) adopt a “prompt corrective action” regime to strengthen the supervisor’s capacity to address emerging risks at an early stage; and (iii) have the supervisor regularly disclose nonconfidential firm-level prudential returns.

  • The UK authorities should continue their constructive efforts to secure an ambitious international package of regulatory reform and rigorous implementation of this package in the EU. In this regard, the authorities have rightly emphasized the need for concrete tools to address risks arising from systemic financial institutions (e.g., through capital and liquidity surcharges and cross-border resolution frameworks).

In general, it will be important to promote internationally coordinated financial sector reform to minimize regulatory arbitrage and to phase in reforms gradually to avoid strangling near-term credit supply.

51. It is recommended that the next Article IV consultation with the United Kingdom be held on the standard 12-month cycle.

Table 3.

United Kingdom: Balance of Payments, 2003–15

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