IMF Executive Board Concludes 2010 Article IV Consultation with 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.

Background

Economic recovery is underway in the UK. 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, private final demand has also begun to recover modestly as the labor market has stabilized, household saving rates have begun to ease, and corporates have begun to increase investment from its low levels. However, past sterling depreciation has not yet boosted net exports as much as expected. 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 on underlying inflation.

The financial crisis has taken a toll on the fiscal position, with the overall deficit (excluding financial sector interventions) in FY 2009/10 (April 6, 2009-April 5, 2010) rising to 11 percent of GDP, one of the highest in the world. To ensure confidence in public finances and avoid adverse market reactions, the government has set itself a fiscal mandate of balancing the cyclically adjusted current budget (by the end of a rolling five-year horizon) and putting the net debt-to-GDP ratio on a declining path by 2015/16, and it has announced plans to achieve these goals one year early. The adjustment is frontloaded and relies mainly on spending restraint, with support from an increase in the VAT rate and other tax measures.

To counter disinflationary pressures and bolster economic recovery, the Bank of England (BoE) has provided unprecedented monetary stimulus: the policy rate has been kept near zero, while £200 billion in asset purchases (mostly of longer-term government bonds) have helped depress bond yields and boost asset prices, thereby supporting market confidence, household net wealth, and corporate credit supply.

Banking sector health has improved, as banks have raised capital, reduced leverage, and increased earnings. Nonetheless, important challenges remain: regulatory requirements are set to tighten over time; uncertainty about the sustainability of bank profits and the quality of some exposures remains significant; and banks will need to raise significant amounts of new funding as public support schemes taper off. Meanwhile, the authorities have laid out plans to revamp the UK’s prudential architecture, consolidating key responsibilities in the BoE.

Looking ahead, economic recovery is expected to continue at a moderate pace as private and external demand progressively gather strength while the public sector retrenches. GDP is projected to grow at 1.7 percent this year and 2.0 percent in 2011. Risks around this forecast are considerable, though broadly balanced, reflecting continued economic uncertainty both globally and in the UK.

Executive Board Assessment

Executive Directors welcomed the stabilization of the UK economy and its return to growth reflecting the authorities’ strong policy actions, including large-scale financial-sector interventions, unprecedented monetary easing, and temporary fiscal stimulus followed by the announcement of a strong and credible multi-year fiscal consolidation strategy. The challenge going forward will be to support a balanced and sustainable economic recovery. With the private sector running high financial surpluses and the public sector running high deficits, sustainable growth will require a gradual rebalancing toward private and external sector-led demand.

Directors generally supported the government’s frontloaded fiscal consolidation, as it preserves confidence in debt sustainability, restores fiscal space to cope with future shocks, and supports rebalancing. They agreed that these benefits outweigh expected costs in terms of a moderate dampening of near-term growth.

Directors noted that the fiscal consolidation plans include an appropriate mix of tax and expenditure measures. They welcomed the authorities’ efforts to preserve priority expenditures, especially those that promote growth, protect vulnerable groups, and support official development assistance. Directors commended the creation of an independent Office for Budget Responsibility and encouraged the authorities to strengthen the fiscal framework further by eventually replacing the current fiscal mandate, an appropriate guide for the consolidation process, with more permanent fiscal rules.

Directors agreed that a highly accommodative monetary stance remains appropriate given the need to maintain overall policy stimulus as fiscal tightening takes hold and financial intermediation normalizes only gradually. This policy mix would facilitate the necessary rebalancing while supporting a moderate-paced recovery and maintaining inflation near the target over the policy horizon.

Directors noted that risks around this central scenario are substantial in both directions. They agreed that a key safeguard against risks is the free operation of automatic fiscal stabilizers. In addition, monetary policy must remain nimble. Policy rates should be raised gradually if output recovers apace and inflation continues to surprise on the upside. Conversely, asset purchases should resume if the recovery weakens and disinflationary pressures mount. In the unexpected case of a significant and prolonged new downturn, some Directors considered that the pace of structural fiscal consolidation could be adapted, market conditions permitting and ideally combined with longer-term entitlement reforms to safeguard fiscal sustainability and market credibility.

Directors supported continued efforts to strengthen financial sector health and reduce related risks to the economy and taxpayer. This includes raising capital buffers over time, unwinding crisis-related public interventions, and maintaining pressure on banks to develop robust new funding models.

Directors welcomed the creation of a Financial Policy Committee with an explicit macroprudential mandate. They emphasized that, to be effective, some macroprudential measures should be internationally coordinated. The transition toward a new prudential architecture also needs to be managed carefully to mitigate operational risks. In addition, Directors encouraged the authorities to continue enhancing the more intrusive, judgment-based, and strategic approach to supervision adopted since the crisis. They also looked forward to the results of the 2011 Financial Sector Assessment Program update, including analysis of issues such as the supervision of foreign banks in the UK and the resolution framework for non-banks.

Public Information Notices (PINs) form part of the IMF’s efforts to promote transparency of the IMF’s views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2010 Article IV Consultation with United Kingdom is also available.

United Kingdom: Selected Economic and Social Indicators, 2006–11

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

ILO unemployment; based on Labor Force Survey data.

The fiscal year begins in April. For example, fiscal balance data for 2006 refers to FY2006/07. 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.

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Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.

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.
Author: International Monetary Fund