Statement by Alex Gibbs, Executive Director for the United Kingdom

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Abstract

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

We thank staff for a very good and comprehensive set of documents based on a number of productive staff missions in the first half of 2011. The reports appropriately capture the views of my authorities and reflect the fact that, for the most part, they agreed with the staff analysis and recommendations.

Outlook and recent economic developments

The 2011 Article IV mission took place just over six months after the 2010 Board discussion. Since then, temporary factors have clouded assessment of the state of the UK economy. The growth numbers have been choppy, with a contraction of 0.5 percent in 2010Q4 reversed by growth of 0.5 percent in 2011Q1. However, as the staff report notes, other economic indicators - including employment data, growth in tax revenues and manufacturing performance - have been suggestive of a stronger recovery.

The weakness in the growth figures relative to forecast largely reflects the impact of transitory factors, including rising energy prices, supply chain disruptions and weather related shocks. The latest forecast from the Office for Budget Responsibility (OBR) projects a sustained recovery, with 1.7 percent growth in 2011 continuing to strengthen before peaking at 2.9 percent in 2013. This is consistent with rebalancing from private consumption and government spending to net trade and investment. The latest survey data indicates that corporate investment intentions remain strong.

On the inflation outlook, while headline inflation is currently at around 4¼ percent, reflecting the increase in VAT, higher energy and import prices, and some rebuilding of companies’ margins, core inflation excluding indirect tax rises is just over 1 percent. Inflation is likely to fall back through 2012 and into 2013 as the temporary impact of those factors wanes and some downward pressure from spare capacity persists. Medium-term inflation expectations remain contained and continue to be consistent with meeting the inflation target.

Fiscal Policy

In their last Article IV report, staff supported the UK Government’s commitment to fiscal consolidation and its ambitious medium-term targets for adjustment, which themselves were consistent with staff advice in previous Article IV consultations.

The 2011 Article IV report highlights that fiscal consolidation is still essential to reduce fiscal risks and achieve a more sustainable budgetary position. My authorities welcome the staff conclusion that the current path of fiscal consolidation remains appropriate in their central case. Since the consolidation path was announced, yields on UK sovereign debt have fallen significantly and remain below the levels at the onset of the euro-area sovereign debt crisis. Retaining fiscal credibility is essential to maintain this improvement in market confidence.

As staff’s very thorough analysis shows, risks still remain, both to the upside and the downside. The economy is still some distance from the risk scenarios set out in the report but the UK authorities are continuing to monitor developments closely. If risks do materialize, the policy response will need to be calibrated to the nature and cause of the particular shock. However, the successful implementation of the Government’s fiscal consolidation plan is the key to maintaining confidence in debt sustainability and will continue to be a prerequisite in any scenario.

Implementation is now fully underway. Consistent with previous staff advice, the plan is tilted clearly to expenditure-based measures: of a total consolidation of £126 billion a year by 2015-16, £95 billion comes through spending cuts and £30 billion through taxation. The Government has delivered the £6.2 billion of savings announced in May 2010 and has implemented departmental budgets and the reforms to welfare and public service pensions that were outlined in the October 2010 Spending Review. Where necessary, legislation has now been introduced to Parliament. Mindful of the need to sustain commitment to implementing spending measures over a period of years, my authorities have established a Public Expenditure Cabinet Committee to oversee departments’ performance. On the revenue side, the Government has put in place the planned 2011-12 tax reforms, including the increase in the standard rate of VAT to 20 percent.

Nevertheless, my authorities remain committed to protecting Overseas Development Assistance from the expenditure cuts, and their spending plans provide for achieving the ODA target of 0.7 percent of GDP.

My authorities welcome the staff advice on further structural reforms that could help address longer-term fiscal pressures and support medium-term growth. Measures have already been taken. For example, the rise in the State Pension Age (SPA) from 65 to 66 has already been brought forward to 2020 from 2026. My authorities have committed to bring forward proposals to manage future increases in the SPA more automatically, as staff propose. Since the Article IV mission, the OBR has published its first Fiscal Sustainability Report, which looks at these issues in detail.

A key focus of the structural reform effort is to ensure sustainable growth, and to that end a Growth Review, launched in November 2010, has identified a programme of structural reforms to boost competitiveness and improve the business environment. The focus is on reforms to the tax system, measures to encourage investment and rebalancing towards exports and action to improve education and skills. Implementation is underway, with 16 of 182 proposed measures already implemented and major milestones passed in 92 others. The second phase of the Growth Review was launched in June and will report in the autumn.

Fiscal Framework

The independent Office for Budget Responsibility (OBR) was established in May 2010 to strengthen the fiscal framework and provide greater transparency and credibility to the official economic and fiscal forecasts – in line with recommendations that the IMF had been making to the UK authorities for a number of years. The OBR has now been placed on a permanent, statutory footing and has produced all the official forecasts of the economy and public finances since the General Election, independently of Ministers.

To promote transparent fiscal policy-making and strengthen the new fiscal framework, my authorities have legislated a new requirement for each Government to set out its fiscal policy objectives and fiscal mandate before Parliament in the Charter for Budget Responsibility. The Government published the Charter on 4 April 2011.

Monetary Policy

The central view of the Monetary Policy Committee (MPC) continues to be that a margin of spare capacity in the economy is likely to push down inflation and bring it back towards the 2 percent target in the medium term, as the impact of factors temporarily boosting inflation subside. However material risks exist in both directions.

At its last meeting earlier this month, the Committee maintained its highly accommodative monetary policy stance, with Bank Rate set at 0.5 percent and asset purchases of £200 billion. A minority of members voted for less accommodative policy - preferring higher Bank Rate - and a smaller minority for an extension of asset purchases.

The MPC will continue to set policy to balance risks around the 2 percent inflation target. If it becomes clear that one of those risks has crystallised – and the medium-term outlook for inflation has deviated materially from the target – the Committee will change its monetary policy stance accordingly. The MPC’s next decision will be on 4 August.

Financial Sector

This year’s FSAP update comes at a critical time when reforms are being pursued in parallel at the domestic, regional and global levels. Collaboration with the FSAP team was excellent and my authorities have found the exercise extremely valuable for policy development. The team has produced a detailed and comprehensive set of reports, including robust analysis and a wide-ranging set of recommendations, which we intend to publish in full. My authorities are now carefully considering how best to take these recommendations forward.

As staff note, the UK financial sector is on the mend. Conditions have continued to improve with UK banks taking major steps to repair their balance sheets. Core tier 1 capital ratios are now above 10 percent for all the major UK banks, the funding gap has continued to decline and the dependence on wholesale funding has been significantly reduced. The in-depth FSAP stress tests, which include haircuts to sovereign and bank debt, demonstrate that the resilience of the sector has increased. Results show that banks have solid capital buffers and are resilient against severe stresses - only an extreme “tail of the tail” risk, with multiple severe shocks would pose a challenge to the banking system. Similarly, even under the Fund’s new and most severe 30-day liquidity stress test scenario – which in effect tests institutions to the point of failure – staff note that liquidity shortfalls remain largely contained.

Having said that, my authorities remain mindful that challenges remain, particularly given the ongoing uncertainties over the global economic outlook. For that reason, the UK is continuing to strengthen its regulatory and supervisory frameworks. In particular, the FSA is continuing to adopt a more proactive and intrusive supervisory approach, including for example, the introduction of a proactive intervention framework to ensure that prudential problems are tackled at an early stage. A new strengthened liquidity regime has also been implemented that imposes stringent resilience requirements under stress conditions and determines the approval of dividends and remuneration policy.

Many of the FSAP recommendations are already being taken forward through the overhaul of the current system of financial regulation and supervision. Much progress has been made since last September to lay the foundations for the move to the ‘triple peak’ model. An interim version of the Financial Policy Committee (FPC) has been up and running since June 2011 – this will have a clear macroprudential remit to identify and address systemic risks. Significant steps have also been taken to clarify the mandates for the new Prudential Regulation Authority (PRA) and the Financial Conduct Authority, which will have responsibility for microprudential regulation and supervision, and conduct of business and market regulation, respectively. The Government published a White Paper and draft Bill in June, which will act as a blueprint for the reforms, and primary legislation is expected to be introduced later this year.

The Government is particularly focused on tackling the risks posed by systemically important financial institutions (SIFIs). The Independent Commission on Banking (ICB) has delivered its interim report and is considering options on bail-in and the ring-fencing of retail banking activities. The Government has endorsed these proposals and will take action to address these issues once the ICB has delivered its final report in September, recognising the impact of ongoing regulatory uncertainty.

As staff stress, a strong international response is vital. Stability in the UK financial sector critically depends on a stronger international framework of oversight for cross-border SIFIs. Given the risks of global regulatory arbitrage and the constraints on oversight of institutions hosted in the UK, domestic reform alone will not ensure stability. The UK is therefore fully committed to the development and implementation of an ambitious international regulatory reform. We will continue to work closely with our European partners and our global partners to ensure full implementation of the Basel III standards around the world. Like staff, we believe national regulators do need discretion to go beyond those standards when national circumstances require to safeguard financial stability. The UK has shown leadership on these matters in international fora, and will continue to do so.

Finally, the Article IV staff report notes that the UK still needs to improve its disclosure of financial sector data. My authorities fully agree and work is underway to deliver this. As part of its commitment to encourage more market discipline, the PRA will seek to publish some regulatory returns and the interim-FPC has requested the FSA to take action to make enhanced disclosure of sovereign and banking sector exposures a permanent part of major banks’ reporting framework. In addition, we have consented to publish all the UK FSAP standard assessment reports and technical notes, including on stress testing, where the IMF has pioneered extremely demanding liquidity tests. Together with the establishment of the OBR, as an independent forecaster, and the publication of the whole of government accounts, these measures represent a significant increase in the transparency of government.

Spillovers

The UK strongly supports the drive to improve the Fund’s analysis of spillovers, particularly its understanding of financial interlinkages. As with the other “S5” spillover reports, the report on the UK is a good first step towards bridging the gap between the Fund’s standard bilateral and multilateral surveillance products.

The UK report focuses almost entirely on financial spillovers. We welcome the staff’s effort to develop better understanding of some financial linkages that are not well captured - if at all - in traditional models. Nevertheless we also recognise that, as with other work in this field, gaps in the data and the lack of an established economists’ financial spillover toolkit increased the difficulty of the task. This is an area of Fund surveillance that merits significant further attention, alongside better modeling of real economy linkages, which the spillover reports overall have tended to downplay.

We agree with the high-level conclusions of the report. The size and interconnectedness of the UK financial sector make it a powerful originator, transmitter and potential dampener of global shocks - more must now be done to understand the complexities of transmission mechanisms and identify more clearly how and when the UK could potentially have these different impacts. The report appropriately stresses the international dimension, as shocks affecting the UK or transmitted through institutions based in the UK, frequently arise elsewhere. Action taken domestically to strengthen capital and liquidity buffers may have an impact on global asset and liability management, but the benefits for global financial stability must surely exceed any potential efficiency costs. In general, we believe the objectives of national and global financial stability are well aligned.

My authorities are strongly committed to continuing to engage in, and exercise leadership on, the global financial repair and reform agenda. Effective global surveillance and regulation will require sustained cooperation with European and global partners, particularly other financial centres, through ongoing work at the IMF, FSB and ESRB.

United Kingdom: 2011 Article IV Consultation: Staff Report; Staff Supplement; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the United Kingdom
Author: International Monetary Fund