United Kingdom
Staff Report for the 2012 Article IV Consultation
Author: International Monetary Fund
Publication Date:
19 Jul 2012
eISBN:
9781475506464
Language:
English
Keywords:
ISCR; CR; FLS loan; government; lending; market lending; BoE liquidity insurance; central bank; potential GDP; financial crisis; fiscal year; banking sector; Monetary expansion; Fiscal consolidation; Global; monetary policy
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This 2012 Article IV Consultation reports that the United Kingdom's economic recovery has been sluggish, as the needed hand-off from public to private demand-led growth has not fully materialized. Economic activity is projected to gain modest momentum in future, but the pace of expansion is expected to be weak relative to the scale of underutilized resources. Executive Directors have welcomed the authorities’ efforts aimed at economic rebalancing. However, they have cautioned that a stalling recovery, high unemployment, and uncertain external conditions continue to present significant challenges.

Abstract

This 2012 Article IV Consultation reports that the United Kingdom's economic recovery has been sluggish, as the needed hand-off from public to private demand-led growth has not fully materialized. Economic activity is projected to gain modest momentum in future, but the pace of expansion is expected to be weak relative to the scale of underutilized resources. Executive Directors have welcomed the authorities’ efforts aimed at economic rebalancing. However, they have cautioned that a stalling recovery, high unemployment, and uncertain external conditions continue to present significant challenges.

The Focus of the Consultation

1. The global economy is struggling to regain its footing amid renewed financial strains. Even relative to this global softness, the UK’s economic recovery has been sluggish. Economic activity is projected to gain some momentum, but the pace of expansion in the UK is expected to be weak relative to the scale of underutilized resources. As a result, the output gap is projected to remain sizeable for an extended period, raising the risk that sustained cyclical weakness will reduce the economy’s productive capacity.

2. Against this background, the consultation focused on policies to support a strong and durable recovery and reduce adverse spillovers to the rest of the world. The report thus addresses the following questions:

  • What explains the sluggish recovery?

  • How should current macroeconomic policies be adapted to provide additional demand support?

  • How can financial sector policies reduce vulnerabilities, support a balanced recovery, and limit negative spillovers to the rest of the world?

  • How should policies respond in case of negative shocks?

Recovery Has Stalled

A. Large Imbalances Have Produced Headwinds for Growth

3. Leading up to the financial crisis, economic growth in the UK was brisk, led by consumption and fueled by declining national saving and rising leverage.1 With the household share of national income falling sharply, households reduced their saving and borrowed more to sustain consumption growth and a housing bubble. Public finances entered the crisis with little policy space and deteriorated sharply when the crisis hit. Much of this deterioration in the fiscal position was structural, reflecting permanent revenue losses and a sharp drop in potential GDP growth during the crisis.

4. Sustainable recovery requires addressing the factors underpinning pre-crisis imbalances, notably leverage and debt, and a rebalancing of demand. In particular, there needs to be a hand-off from public to private sector-led demand, notably greater investment and net exports. However, this rebalancing will not be frictionless and so must be paced to minimize disruptions to growth. To support such growth and prevent another buildup of imbalances and stability risks, financial sector repair and reform is also needed. As discussed next, progress on these fronts has been mixed.

B. Growth Has Stagnated and the Output Gap Remains Large

5. The big picture on growth is one of stagnation since late-2010 (Figures 1 and 2). After turning negative in the last quarter of 2010, growth recovered modestly to 0.7 percent in 2011 before declining again by 0.3 percent in the first quarter of 2012, in line with renewed economic weakness in advanced Europe. This broad stagnation has left output per capita a staggering 14 percent below its pre-crisis trend and 6 percent below its pre-crisis level.2

Figure 1.
Figure 1.
Figure 1.
Figure 1.

Real Sector Developments

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Bank of England; British Chambers of Commerce; Office for National Statistics; and IMF staff calculations.1/ Bank of England Agents' Survey, manufacturing.2/ Bank of England Agents' Survey, services.3/ GfK Consumer Confidence Barometer.
Figure 2.
Figure 2.
Figure 2.
Figure 2.
Figure 2.

Behavior of Macro Variables Around Recession Times 1/

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

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Haver Analytics; and IMF staff calculations.1/ The starting point of recessions is marked from the previous peak in GDP.

6. Weak growth has kept unemployment high at 8.2 percent (Figure 3), with youth unemployment (21.9 percent) particularly worrisome. Relative to growth, however, labor markets have been surprisingly resilient, with fewer employment losses than in the aftermath of previous major UK recessions. This stark divergence between growth and employment has left labor productivity well below its pre-crisis trend.

Figure 3.
Figure 3.
Figure 3.
Figure 3.

Labor Market Developments

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Haver Analytics; Office for National Statistics; and IMF staff calculations.1/ Estimates based on provisional data from the International Passenger Survey.
uA01fig1

Employment around Recessions

(Last pre-recession quarter t-1 = 100)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

uA01fig2

UK: Productivity

(index)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Haver and Staff estimates.

7. The reasons for this poor labor productivity performance are much debated.3 The debate is fundamentally about the size of the output gap, with at least three points of view:

  • “Supply pessimists” contend that the drop in productivity is mainly permanent, implying a small output gap. They argue that (i) the pre-crisis productivity level and trend reflect an unsustainable credit boom and (ii) historical evidence of past financial crises points to large and persistent output losses, in part due to tight post-crisis credit conditions that limit investment and the reallocation of capital to more productive activities. As further evidence of limited supply capacity, pessimists cite elevated inflation (exceeding 5 percent in late 2011), the relatively restrained increase in unemployment, and the limited spare capacity reported by businesses (Figure 4).

  • “Supply optimists” contend that such a large “technology reversal” from pre-crisis levels is implausible and that the pessimists’ points do not hold up to scrutiny: the financial crisis story cannot explain the much stronger productivity growth in other countries experiencing financial crises, such as the US and Spain; high inflation over the past two years can be completely explained by transitory shocks, such as indirect tax hikes and commodity price shocks (paragraph 22); and business surveys of capacity are notoriously unreliable. Stories of structural shifts from high to low productivity sectors can explain at most a small part of the shortfall when quantified, as the productivity drop is broad-based across sectors. Optimists argue that restrained unemployment and low productivity can instead be explained by labor hoarding, as weak real wage growth points to significant slack in labor markets. This implies that the output gap is large and that, with more demand, labor hoarding would unwind and productivity would rebound toward its previous trend.

  • “Statistics skeptics” note that both labor market resilience and PMI readings during the last 18 months suggest possible underestimation of growth in official statistics, which are subject to large ex post revisions. Such revisions would shrink differences with the pre-crisis GDP trend. However, such revisions are very unlikely to be big enough to explain a majority of this gap.

Figure 4.
Figure 4.
Figure 4.
Figure 4.

Indicators of Capacity Utilization

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Haver Analytics; 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 the 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.

8. All analysts nevertheless agree that the output gap is negative and the debate is about the magnitude. Given the uncertainty regarding the accuracy of specific methodologies, staff bases its output gap estimates on a broad range of indicators—including two filter models, a production function model, and a model based on Okun’s Law—and finds a large output gap of about -4 percent in 2012, which persists at this level into 2013. The independent Office for Budget Responsibility (OBR) relies mostly on the limited spare capacity reported by businesses to arrive at the official output gap estimate of -2.7 percent of GDP in 2012.

C. Internal Rebalancing Has Not Fully Materialized

9. The tepid recovery reflects weak and inadequate rebalancing of domestic demand. Specifically, it has been one-sided. On the side of the public sector, large and frontloaded fiscal adjustment has, as expected, been an important headwind. Consolidation amounting to a cumulative 4¾ percent of potential GDP in FY10/11 and FY11/12 is estimated to have subtracted roughly 2½ percentage points from growth during these two years. But against this, underlying private domestic demand (i.e., demand before the effects of consolidation) has been insufficiently strong to keep total domestic demand growth from turning negative on average since 2010 (Figures 1 and 2).

Private consumption has declined sharply

10. Real private consumption declined at a 1 percent annual rate over the last 18 months. This can be attributed largely to ongoing household balance sheet repair. The shock to households’ balance sheets from the fall in house prices during the crisis, as well as more subdued expectations for house price appreciation going forward, has contributed to a sharp increase in the household saving rate to about 7½ percent (Figure 5), as households seek to reduce their high level of indebtedness. Debt-to-income ratios have fallen from their pre-crisis peaks, although they remain high both from a historical and cross-country perspective (Figure 5).

Figure 5.
Figure 5.
Figure 5.
Figure 5.

Financial Position of Households

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Haver Analytics; OECD; and IMF staff calculations.1/ 2010 data for Italy and Japan.2/ 2010 data for Germany.

11. In addition, private consumption has been held back by weak household incomes and low consumer confidence. Real household income declined by 1.2 percent in 2011, as higher global commodity prices and a 2½ percentage point VAT increase drove up inflation and reduced households’ spending power. Household finances were further squeezed as growth in nominal wages remained low amid high unemployment. At the same time, consumer confidence fell to levels not seen since the Lehman crisis due to high commodity prices, concerns about job prospects, and heightened turmoil in the euro zone.

Private investment has fared better, but has not been sufficiently robust to power recovery

12. Real private fixed investment grew at an average annual rate of 3 percent over the last 18 months. Although this better performance relative to consumption is consistent with rebalancing objectives, private investment has been insufficiently strong to recover from its 24 percent collapse during 2008-09 or to offset contraction of other elements of domestic demand during the recovery. In explaining this reluctance to unleash investment, respondents to industrial surveys point to uncertainty about future demand as the overarching factor. Indeed, the escalation of euro area turmoil in the latter half of 2011 led to an accompanying reduction in investment intentions by firms (Figure 1).

Financial sector conditions have affected private demand

13. Notwithstanding an accommodative monetary policy stance, credit conditions remain tight due to an incomplete process of financial repair (Box 1) and high risk premia in the wake of the crisis, which have been exacerbated by escalating stress in the euro area. Tight credit conditions are in turn constraining private demand. Specifically:

  • Bank lending rates have fallen much less than the policy rate due to higher risk premia in the wake of the 2008-09 financial crisis. Indeed, the observed average lending rate overstates the true drop in lending rates, as the composition of lending has shifted toward lower-risk credit (e.g., higher credit scores are required for mortgages). Bank funding costs have also risen over the last two years in line with escalating euro area tensions, such that 5-year CDS spreads for some major UK banks are now near record highs and exceed their Lehman-crisis peaks (Figure 6). These higher funding costs have in turn squeezed net interest margins on loans and reduced banks’ incentive to lend.

  • Partly reflecting these factors, broad money (M4) and real credit growth to the nonfinancial private sector have been negative for the last two years. SMEs, which account for more than 50 percent of private-sector employment, have been particularly constrained. Bank of England (BoE) credit surveys confirm that credit availability and lending conditions remain much tighter than pre-crisis levels (Figure 7).

uA01fig4

Key Interest Rates

(Percent)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Bloomberg; and Bank of England.1/ Calculated as the sum of the 3-month Libor plus the 5-year CDS premia. For more details, see Bank of England Quarterlly Bulletin, Vol. 50, No. 3, pages 174-75.

14. This said, demand factors may have also contributed to weak credit growth. Banks report a considerable decline in the demand for loans (Figure 7). Household loan demand started to recover in early 2009, but has fallen again since 2010. The contraction in corporate loan demand possibly reflects a substitution away from bank borrowing and toward a greater reliance on debt markets. Indeed, capital markets have provided an alternative source of funding for larger companies, with bond issuance more than offsetting the decline in lending over the last two years.

uA01fig5

Real Growth of Broad Money (M4) and Lending

(Annual growth, percent)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Source: Bank of England.
uA01fig6

Cumulative Net Funds Raised by UK Companies 1/

(Billions of British Pounds)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Source: Bank of England.1/ 2012 data are for January -April.

15. Going forward, some factors that have mitigated the impact of banks’ deleveraging and regulatory requirements on credit availability may dissipate. This could further constrain credit expansion and the pace of recovery. These factors include:

  • Capital-raising efforts. About two-thirds of the increase in capital ratios since 2008 reflects direct capital measures, with the majority of this being government capital injections. More recently, reliance on asset-shedding and risk weight optimization has increased, though some of this reflects necessary post-crisis restructuring under state aid rules.

  • Post-crisis restructuring. Balance sheet repair has focused on addressing legacy assets and restoring the conditions for a sound banking sector. Future restructuring targets will be more difficult to achieve, as the low-hanging fruit for repairing balance sheets has already been plucked.

  • Reduction of intra-financial assets. Most of the contraction in UK banks’ balance sheets since 2008 has concentrated on derivatives positions and intra-financial system lending, thereby reducing interconnectedness and the fragility of the financial system. The scope for further reduction of intra-financial activity may be limited, as this activity also provides funding and supports the real economy.

uA01fig7

Contributions to the Change in Major UK Banks' Core Tier 1 Capital Ratios

(Percent)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Bank of England; and IMF staff calculations.
Figure 6.
Figure 6.
Figure 6.

UK vs. Euro Area: Recent Developments in Global Financial Markets

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Bloomberg; Datastream; and IMF staff calculations.
Figure 7.
Figure 7.
Figure 7.

Credit Survey: Supply and Demand Factors

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Source: Bank of England Credit Survey.

The Health of UK Banks

Stress in UK banks’ funding and equity markets intensified in the second half of 2011 as euro area stress intensified. UK bank equity prices fell, and CDS spreads for some major UK banks rose sharply above their previous peaks reached during the Lehman crisis. Nonetheless, UK banks’ CDS spreads remained below those of many core euro area banks. In turn, interbank funding and US$ basis swap spreads widened, though significantly less than in the euro area (Figure 6). This reflected to some extent the limited reduction in US money market fund (MMF) exposures to UK banks relative to those in France and other euro area economies.

uA01fig3

US Money Market Fund (MMF) Exposures

(Percent of total MMF assets under management)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Source: Fitch.

Funding conditions improved following special policy measures. UK banks’ CDS spreads came down from their peak levels in late 2011 as the ECB provided LTROs and the Fed expanded its US$ swap facilities with the ECB, BoE, and other national central banks. Staff analysis suggests that these policies had positive spillovers to UK banks, some of which participated directly in the LTROs.

After a brief respite, financial market stress has re-intensified. Renewed euro area turmoil in May-June prompted the average CDS spread for UK banks to spike back near record levels, tracking core euro area banks. Following BoE announcements in mid-June of steps to ease bank funding strains (paragraph 34-35), UK bank CDS spreads eased somewhat, including relative to core euro area banks, but remain high (Figure 6).

uA01fig8

Impact of Central Banks' Policies on UK Banks' CDS Spreads

(Difference between the spread 5 days after and 5 days before the announcement, basis points, average for main banks)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Bloomberg; and staff estimates.

Progress in strengthening banks’ balance sheets and funding profiles slowed over the last year.

  • Capital ratios have been broadly flat. The pace of capital-raising has slowed sharply over the last two years, and reliance on cutting risk-weighted assets to boost capital ratios is increasing. Core tier one capital ratios of major UK banks, at over 10 percent, are above-average in Europe, but compare less favorably to US and Asian peers. Furthermore, analyst estimates suggest that UK banks are still about 25 percent below the capital levels that will be required under fully-loaded Basel III, not including additional top ups for the countercyclical buffer. Last year’s European Banking Authority (EBA) stress tests and capital adequacy exercise did not identify any capital shortfall for UK-owned banks. The exercise confirmed that UK banks’ direct exposures to vulnerable sovereigns are limited, but exposures to the private sector in these countries and indirect exposures through other euro area banking systems are more substantial.

  • Liquidity and funding profiles are gradually improving. Loan-to-deposit ratios have continued to trend down as banks were successful in expanding their deposit bases (Figure 8). Reliance on market wholesale funding increased slightly as banks refinanced away from central bank and government facilities (SLS/CGS). This was partly offset by the disposal of non-core assets, which reduced the need for wholesale funding. Funding needs this year appear manageable, with banks ahead of schedule in their funding plans.

uA01fig9

UK Banks' 2011 Core Tier 1 Capital Ratios under Basel II and Basel III Definitions

(Percent)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Citi; and Banks' accounts.

  • The restructuring of the government-supported banks is ahead of schedule. The reduction of non-core assets has enabled these banks to improve its funding mix as well as capital positions.

  • Asset quality is broadly stable. The system-wide NPL ratio was essentially unchanged in 2011 at a manageable 4 percent. However, impairments remain substantial for some banks and segments, especially non-UK exposures. Rapid reductions in non-core assets, which represent the majority of credit losses so far, imply that credit losses should slow down.

uA01fig10

Bank Leverage 1/

(Adjusted in percent)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: SNL; and IMF staff estimates.1/ Tangible assets are adjusted for accounting differences in derivatives.
uA01fig11

Bank Loan-to-Deposit Ratio

(Percent)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: SNL; and IMF staff estimates.

  • But forbearance adds to uncertainty. An FSA review in June 2011 concluded that about a third of commercial real estate loans and 5-8 percent of residential mortgages are subject to some form of forbearance. These forborne loans are more highly provisioned for and hence the FSA concluded that such forbearance was unlikely to be of systemic importance. Nonetheless, the prevalence of forbearance increases the uncertainty regarding the exact state of banks’ balance sheets. The FSA is now extending the review to analyze (i) differences in forbearance across banks and (ii) some loan types not covered by the initial review.

  • Profitability has weakened. System-wide profitability declined slightly in 2011, and the two government-supported banks reported losses. Profitability has been affected by still-high impairments (mainly on non-UK exposures), non-core disposal losses, one-off factors (e.g., charges for mis-sold payment protection insurance), and higher wholesale funding costs as strains in Europe intensified.

uA01fig12

Debt Issuance by Bank

(Billions of U.S. dollars)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Source: SNL.
uA01fig13

Maturity Profile by Bank

(Billions of U.S. dollars)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Source: SNL.

D. Progress Has Been Made in Rebalancing Toward External Demand

16. Net exports have contributed much more to growth during this cycle than during the previous two recoveries and account for essentially all of the growth since 2010 (Figures 1, 2, 9). Fiscal consolidation and private-sector deleveraging have been factors behind this external adjustment, as they have suppressed growth of domestic demand below that of foreign demand. Another significant factor has been the depreciation of the sterling exchange rate, which declined by about 25 percent in real effective terms (CPI-based) at the onset of the crisis and has since appreciated only modestly. However, the depreciation of the unit labor cost (ULC)-based real effective exchange rate has been more muted due to weak productivity growth.

Figure 8.
Figure 8.
Figure 8.
Figure 8.

UK vs. Other European Banks: Main Banking Sector Indicators 1/

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Bankscope; and IMF staff calculations.1/ These data only include banks that participated in the recent European-wide stress tests under the auspices of the EBA and that have reported data for 2011. For the UK, this sample of only the four largest banks results in differences with some system-wide numbers reported in the main text (e.g., for NPL ratios). The “EBA banks” group excludes UK banks. 2011 refers to end-2011 or latest quarter available.
Figure 9.
Figure 9.
Figure 9.
Figure 9.

External Sector Developments

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Haver Analytics; IMF's International Financial Statistics; and IMF staff calculations.
uA01fig14

Real Effective Exchange Rate

(Index, 2005Q1 = 100)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

uA01fig15

Net International Investment Position (IIP) and Current Account

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Haver Analytics; and IMF staff calculations.

The external position is modestly weaker than implied by fundamentals and desirable policy settings

17. Staff estimates the cyclically-adjusted current account balance to be about 1-2 percent of GDP below its equilibrium value and sterling to be overvalued by 5-10 percent.4 This reflects several considerations:

  • Moving to a more sustainable fiscal position is expected to increase the cyclically-adjusted current account balance by 1-2 percent of GDP, from -2 percent of GDP in 2011 to around -½ percent of GDP in the steady state. Similarly, a cyclically-adjusted current account of roughly -½ percent of GDP is needed to stabilize the UK’s net international investment position (IIP), which was -13 percent of GDP at end-2011.

  • A macroeconomic scenario that yields adjustment of the current account to around -½ percent of GDP in the medium term is consistent with exchange rate depreciation of 5-10 percent.

  • A simple comparison of the UK price level to countries at a similar level of income suggests overvaluation of a similar magnitude.

  • One downside risk to this assessment (implying a smaller degree of overvaluation) is the possibility that an unwinding of labor hoarding could boost productivity and competitiveness. In this case, the current account could adjust to more sustainable levels without as much real depreciation. However, such a productivity burst is uncertain.

  • Balancing this is an upside risk that the degree of overvaluation is larger: the UK’s small net IIP position masks large gross liabilities (over 600 percent of GDP), reflecting its status as a major financial center. Several other major financial centers (e.g., Singapore and Switzerland) have large positive IIPs, which may in part reflect precautionary saving against these large gross liabilities and capital flows. If the UK’s equilibrium IIP were also to be higher than its current level, this would suggest more overvaluation. One factor that perhaps mitigates the need for such precautionary balances is the current structure of the UK’s IIP: its external assets have a larger foreign-currency component relative to its external liabilities, such that sterling depreciation acts as a powerful “automatic stabilizer” of the IIP.

uA01fig16

Relative Price Level vs. GDP Per Capita in 2011

(PPP basis)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Source: IMF staff calculations.

Outlook, Risks, and Policy Implications

Recovery is expected to gain modest traction in the second half of this year

18. Quarterly growth will be choppy in 2012, as extra holidays depress growth in Q2 and the Olympics boost it in Q3. However, staff and consensus forecasts expect underlying growth to accelerate to roughly a 1½ percent annual rate over the next 12 months under a scenario in which actions are taken to ease euro area tensions and substantially avoid US fiscal cliff effects. With government expenditure contracting, such an acceleration is expected to be driven by private demand:

uA01fig17

Annual Contributions to Growth

(Percentage points)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Haver; and IMF Staff estimates.
Figure 10.
Figure 10.
Figure 10.
Figure 10.

Residential Housing Markets

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Bank of England; Haver Analytics; OECD; UK Communities and Local Government; UK Council of Mortgage Lenders; UK Department for Work and Pensions; UK Office for National Statistics; US Census Bureau; US Mortgage Bankers Association; and IMF staff calculations.
uA01fig18

Key Measures of Housing Valuation

(Historical average = 100)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Haver Analytics; Land Registry; UK Dept. for Work and Pensions; and IMF staff estimates.
uA01fig19

House Price Affordability

(Rolling four quarters, percent)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

  • Private consumption. Household real disposable income growth should improve as the effects of past consumption tax hikes and oil price shocks fade. However, the soft housing market and the still high level of household debt are likely to keep the acceleration in consumption restrained. Despite a fall in house prices at the onset of the crisis and a broadly flat market over the last two years, the house price-to-income ratio remains roughly 30 percent above its historical average (Figure 10). Although the above-average ratio can be partially explained by the trend decline in real interest rates over the past two decades and by supply constraints due to tight planning restrictions, historical experience suggests that such elevated ratios do not persist. As such, staff projects house prices to decline relative to income by roughly 10-15 percent over the medium term, with consequent adverse effects on consumption via wealth effects (see 2011 UK Selected Issues Paper).

  • Investment. With investment at historically low levels as a percent of GDP, there is much room for it to rebound as global growth prospects improve and as uncertainty falls due to an easing of euro area turmoil.5 Such a recovery in investment should be supported by low interest rates and strong corporate cash positions.

  • Net exports. As the euro area accounts for roughly half of the UK’s overall trade, export growth in the first half of 2012 is expected to be weak given the weak outlook for the region. But exports should strengthen toward the end of the year in line with a modest pick-up in growth in both the euro area and the US. Over the medium term, net exports are expected to continue to register a positive contribution to growth. Central to this outlook is the assumption of low real effective exchange rates, as the relative demand for nontradables remains low in light of the ongoing fiscal consolidation and private-sector deleveraging.

uA01fig20

Private Investment-to-GDP Ratio

(Percent; dashed segment indicates forecasts)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: ONS; and IMF staff estimates.

But the large output gap will narrow only gradually, raising the risk of hysteresis

19. In staff’s central scenario—which is based on an unchanged monetary stance and current fiscal plans (paragraphs 26 and 40)—growth is projected to accelerate to only around 2½ percent in the medium term, given continued correction of fiscal imbalances and other headwinds (Tables 2 and 3). As a result, the output gap is projected to remain large for an extended period and not close until 2018. This would further establish this recovery episode as the weakest on record.

Table 1.

United Kingdom: Selected Economic Indicators, 2008–13

article image
Sources: Bank of England; IMF's International Finance Statistics; IMF's Information Notic System; OHM Treasury; Office for National Statistics; and IMF staff estimates.

ILO unemployment; based on Labor Force Survey data.

The fiscal year begins in April. Data exclude the temporary effects of financial sector interventions. Debt stock data refers to the end of the fiscal year using centered-GDP as a denominator.

2012: actual data through April.

Average. An increase denotes an appreciation.

Based on relative consumer prices.

Table 2.

United Kingdom: Medium-Term Scenario, 2007–17

(Percentage change, unless otherwise indicated)

article image
Sources: Office for National Statistics; and IMF staff estimates.

Percentage change in quarterly real GDP in the fourth quarter on four quarters earlier.

Contribution to the growth of GDP.

In percent of GDP.

In percent of potential GDP.

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

Whole economy, per worker.

Percent of total household available resources.

Table 3.

United Kingdom: Statement of Public Sector Operations, 2009/10–16/17 1/

(Percent of GDP, unless otherwise noted)

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

Excludes the temporary effects of financial sector interventions, unless otherwise noted, as well as the one-off effect on public sector net investment in 2012/13 of transferring assets from the Royal Mail Pension Plan to the public sector, unless otherwise noted.

Includes depreciation.

On a Maastricht treaty basis. Includes temporary effects of financial sector interventions.

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

IMF staff projections based on 2012 Budget expenditure plans and staff's macroeconomic assumptions.

uA01fig21

Recovery Relative to Previous Recessions

(Index = 100 at per-capita output peak; x-axis is in quarters)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: NIESR; ONS; and Haver Analytics.

20. The large and persistent output gap raises the risk of hysteresis effects, where factors arising from a cyclical downturn depress potential GDP permanently. These factors could include skill erosion from persistently high long-term unemployment, scrapping of idle capital, and inadequate investment eroding the capital stock and hindering the development of new technologies. Indeed, staff’s central scenario assumes that hysteresis effects will lower potential GDP growth by about a third of a percentage point annually on average over the medium term, with other lingering effects of the crisis (e.g., restrained global demand for financial services) taking off another fifth of a percentage point.6 The magnitude of hysteresis effects are uncertain, but cross-country experience with persistent large output gaps suggests that hysteresis effects in this range are plausible (Annex 1).

21. The authorities’ latest official projections assume somewhat higher near-term growth than staff’s projections, but this may partly reflect that these official projections are more dated and do not incorporate the latest data, which have been downbeat. The OBR’s medium-term growth projections are also higher than staff’s, as the OBR assumes a more rapid return to historical potential growth rates and less lingering effects from hysteresis and the crisis (Table 3). Both the authorities and staff project a similar composition of medium-term growth.

uA01fig22

Comparison of Real GDP Growth Projections

(Percent)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

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

Inflation is currently elevated, but is expected to fall below the 2 percent target in the medium term under current policies

22. A series of indirect tax hikes and commodity price shocks have kept inflation above target since January 2010 (Figure 11). With these effects starting to ease, inflation is now falling, reaching 2.8 percent in May 2012 after peaking at 5.2 percent in late 2011. Further disinflation is expected going forward, as the large output gap exerts disinflationary pressure and as the effects of past shocks continue to fall out of the headline rate. Staff expects inflation to eventually fall to around 1.7 percent—modestly below the target—by end-2013. Core inflation, which is currently running close to 2 percent, testifies to a lack of strong underlying inflationary pressure. Additional evidence includes anemic nominal wage growth of 2 percent and broadly stable inflation expectations.

Figure 11.
Figure 11.
Figure 11.
Figure 11.

Price Developments

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Sources: Bank of England; Office for National Statistics; and IMF staff calculations.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. RPI inflation tends to be higher than CPI inflation.
uA01fig23

Unit Labor Costs and Wages

(Annual growth of 4-quarter moving average, percent)

Citation: IMF Staff Country Reports 2012, 190; 10.5089/9781475506464.002.A001

Source: Haver Analytics.