Statement by Alex Gibbs, Executive Director for the United Kingdom, July 16, 2012

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.

I thank staff for a very good and detailed report which reflects a productive mission. My authorities agree with much of the analysis and advice. However, they caution against setting a timetable for potential future fiscal policy actions. The uncertainty of the policy environment, the risks attached to discretionary fiscal easing and the need to calibrate any response to the circumstances – as stressed in the 2011 staff report – means any such timetable is unlikely to prove a useful guide to policy.

Economic Outlook

The UK is estimated to have contracted by 0.3 per cent in each of the last two quarters, meaning that growth over the past 18 months has been broadly flat. This largely reflects the impact of external factors, including the earlier rise in commodity price-driven inflation that hit real incomes and the ongoing euro-area debt crisis, which continues to undermine confidence and investment. Despite these difficult conditions, in the three months to April unemployment fell by 51,000 to 8.2 per cent and 166,000 new jobs were created.

Growth is expected to remain uneven and choppy through the rest of 2012 as public holidays and the Olympic Games have an impact on output, but the central case is still for a gradual recovery. In March the independent Office for Budget Responsibility (OBR) forecast subdued but positive growth of 0.8 per cent for 2012, 2.0 per cent in 2013 and then 2.7 per cent in 2014 as the recovery gains traction. A rebalancing from consumption and government expenditure to net exports and investment was still expected.

CPI inflation fell to 2.8 per cent in May from the peak of 5.2 per cent in September 2011 as the effects of the earlier rise in energy prices and VAT fell away, making space for monetary policy action. Against the background of continuing tight credit conditions, fiscal consolidation and increased drag from the heightened tensions within the euro area, the MPC judged that, without additional monetary stimulus, inflation was more likely than not to undershoot the 2 per cent target in the medium term.

My authorities agree with staff that the exceptional economic environment warrants a supportive macroeconomic policy stance. A number of steps have already been taken to achieve this, consistent with the Government’s well-established economic strategy based on: fiscal consolidation; monetary activism; financial sector reform; and growth-friendly microeconomic reform.

Fiscal Policy

The UK Government has made a strong commitment to fiscal consolidation. It set out a clear and credible plan to put the public finances back on a sustainable path and created the independent Office for Budget Responsibility (OBR) to monitor it. Despite difficult conditions, fiscal consolidation, which staff have judged to be essential, remains on track. The deficit in the cyclically adjusted primary balance has been halved over the last two years (from -7.0 per cent of GDP in 2009-10 to -3.4 per cent of GDP in 2011-12) and by the end of 2011-12 almost 40 per cent of the annual consolidation planned for the 2010 Spending Review period has been achieved.

The Government reacted to the structural deterioration in the OBR’s forecasts in the Autumn Statement of October 2011. Although the Government continued to implement their detailed consolidation plans, the flexibility built into the fiscal framework allowed for the pace of structural adjustment to slow in the near term, letting the automatic stabilizers operate freely. At the same time, to restore the public finances to a sustainable path the period of planned consolidation was extended by a further two years (2015-16 and 2016-17). My authorities welcome the staff view that this approach has been appropriate.

Consolidation plans are still focused on expenditure-based measures, consistent with IMF advice. Around 80 per cent of the total consolidation in 2016-17 will be delivered by lower spending. Further steps have also been taken to improve the composition of consolidation. In the Autumn Statement, savings from current spending (generated over the Spending Review 2010 period), including from public sector pay restraint, were used to create room for one-off increases in high-quality, growth-enhancing capital spending. These changes complement the progress made with the UK’s Growth Review, including the Plan for Growth and National Infrastructure Plan. This programme of over 250 reforms and infrastructure investments includes plans to: cut the main rate of corporation tax by six per cent; save businesses over £3 billion through deregulation; invest over £1billion in road infrastructure; and create 450,000 apprenticeships. A further implementation update will be published later this year.

Staff have highlighted the potential for further budget-neutral reallocations from low- to high-multiplier items and further structural reforms. They also raise the case for discretionary fiscal easing in the event that the recovery fails to take off. The Government is already looking to see if further support for growth can be provided using the credibility of its balance sheet to boost credit for business, housing and infrastructure. As noted above, consideration of any further policy response would need to take account of the specific circumstances at the time and the scope to use other policy levers. The potential benefits of a fiscal response would need to be weighed against the risks of losing fiscal credibility, including the potential for negative feedback loops between weak public finances and the UK’s large and systemically important financial sector. In an environment of ongoing financial market stress, this risk would be particularly relevant.

Fiscal credibility is hard won and easily lost. The costs of losing fiscal credibility would be damaging for both the UK, but also for the wider global economy given the potential for financial spillovers. As staff highlight in their spillover analysis, UK financial stability is a global public good.

Monetary Policy

Having judged risks to have shifted to the downside and, in the absence of additional monetary stimulus, that inflation was more likely than not to undershoot the target in the medium term, the MPC recently voted to increase the size of its programme of asset purchases by £50 billion to a total of £375 billion. The MPC continues to view asset purchases as an effective tool for lowering interest rates, supporting asset prices and therefore nominal demand.

Staff have raised the question of whether the Bank could purchase private sector assets. The MPC continues to see limited scope for this given the relatively small size of the UK market and as a rule would seek to avoid becoming the market maker of last resort in situations where it was not completely necessary.

Although the MPC voted to maintain Bank Rate at 0.5 per cent, it has recently considered the merits of further reductions. Given the potential to squeeze some lenders’ interest margins and their ability to lend, as well as the risks of impairing the functioning of money markets, the MPC judged that further reductions could be counterproductive and would not have any advantages over further asset purchases. However, this position will be kept under review.

Credit Easing and Bank Liquidity Funding Schemes

As euro area concerns have intensified, the UK authorities have focused on developing targeted policy responses to counter the tightening of financial conditions and the increase in bank funding costs. In the spring, the Government launched the National Loans Guarantee Scheme to boost lending to small and medium sized businesses. This credit easing scheme aims to provide £20 billion of government guarantees over two years to enable banks to attract funding at more favourable rates so that the benefits can be passed on to SMEs.

More recently, the Government and the Bank of England have launched two new schemes in response to a continued lack of credit availability for businesses and households: the Extended Collateral Term Repo Facility (ECTR) to address market-wide shortages of short-term sterling liquidity; and the “Funding for lending’ (FLS) scheme to allow high-street banks to temporarily swap illiquid assets for more liquid ones in return for sustained or increased lending to the real economy. The ECTR is already up and running and the details of the funding for lending scheme are being finalised. These schemes respond directly to recommendations made during the Article IV mission and have been welcomed by staff.

Financial Sector

As staff note, UK banks have made valuable progress in rebuilding capital and liquidity buffers in recent years and this has ensured that they remain relatively resilient in the face of ongoing, elevated financial market stress. However, more still needs to be done to ensure that they are in the best possible shape to weather the current, and any future, financial storms. It is vital that they are able to absorb potential losses and maintain lending to the real economy.

To this end, the interim Financial Policy Committee (FPC) has recently recommended that the Financial Services Authority (FSA) encourage UK banks to build capital buffers without exacerbating market fragility or reducing lending to the real economy. The FPC has also recommended that the FSA makes it clearer to banks that they are free to use their regulatory liquid asset buffers in the event of a liquidity stress. It also recommended the FSA to review its liquidity guidance, taking into account that additional liquidity insurance is more readily available from the Bank of England. These recommendations are consistent with staff advice.

Broader reform of regulatory and supervisory structures is continuing against the challenging background of ongoing financial market stress and the international and European reform agenda. As staff note, progress has been made in implementing most of the related FSAP recommendations. The Financial Services Bill was introduced in January 2012 and is expected to come into force in early 2013. The move towards the new model is now well underway, with the FSA trial running the new Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) structures within the existing system. This is already facilitating an intensification of supervision and a focus on the 'safety' of the system – both key FSAP recommendations.

The FSAP raised concerns about the lack of clarity with the mandates of these new institutions. My authorities believe that the legislation addresses these concerns. The PRA will have the general objective of promoting the safety and soundness of regulated firms, complemented by an additional objective of policyholder protection which will only apply when regulating insurers. The FCA will have an overarching objective to make markets function well, but this will include an explicit responsibility to protect and enhance the soundness, stability and resilience of the financial system. In addition, the FPC will be given a secondary objective to support the Government’s economic policy, consistent with the aim of balancing economic growth with financial stability.

The Government has pushed ahead with efforts to address the risks associated with systemically important financial institutions (SIFIs). A recent White Paper sets out detailed plans to implement the recommendations of the Independent Commission on Banking, including: proposals for retail deposits to be ring-fenced from international wholesale and investment banking; and an additional 3 per cent of equity in addition to the Basel III minimum standards for the largest UK ring-fenced banks. The paper also supports the Basel proposal for a binding 3 per cent minimum leverage ratio for all banks and as staff suggest, the UK will continue to press for this in EU discussions. My authorities welcome the staff conclusion that these plans will help limit the frequency and severity of banking crises and strengthen the resilience of the UK financial system.

Improving the disclosure of financial sector data to enhance market discipline continues to be a priority for my authorities. The PRA intends to publish some regulatory returns and this will be developed in earnest with the implementation of harmonized reporting under CRDIV in the EU. The FPC has recognised the potential role of disclosure in fostering financial stability and outlined when it will intervene on specific disclosure and transparency issues. Most recently, it recommended that UK banks work with the FSA and the British Bankers’ Association to ensure greater consistency and comparability of existing Basel II Pillar 3 (Market Discipline) disclosures, beginning with the accounts for the current year.

Domestic financial sector reform needs to be complemented by a stronger EU and international regulatory and supervisory framework. I welcome staff’s call for international collaboration and continued UK leadership and can confirm that the UK remains fully committed to the global reform agenda, including the full and faithful implementation of the agreed Basel III standards.