This staff report on United Kingdom’s (UK) 2013 Article IV Consultation highlights economic policies and development. The UK economy grew by about ¼ percent in 2012. Net trade reduced growth by 0.6 percentage points of GDP, the biggest drag since 2005, and well above staff projections. Domestic fixed capital investment was essentially flat, leaving household spending the main source of private demand, but still substantially below long-run potential growth. In terms of production, construction has been particularly affected by the financial crisis, and the mining sector has been experiencing a secular decline, accelerated in part by temporary shutdowns in North Sea oil extraction.

Abstract

This staff report on United Kingdom’s (UK) 2013 Article IV Consultation highlights economic policies and development. The UK economy grew by about ¼ percent in 2012. Net trade reduced growth by 0.6 percentage points of GDP, the biggest drag since 2005, and well above staff projections. Domestic fixed capital investment was essentially flat, leaving household spending the main source of private demand, but still substantially below long-run potential growth. In terms of production, construction has been particularly affected by the financial crisis, and the mining sector has been experiencing a secular decline, accelerated in part by temporary shutdowns in North Sea oil extraction.

The Focus of the Consultation

1. The recovery remains fragile, held back by deleveraging, impaired credit creation, and weak external demand. Growth is expected to be stronger in 2013 than in 2012, but nonetheless modest, and will be insufficient to substantially close the large negative output gap. The more growth disappoints, the greater the risk of permanent damage to potential growth. Hence, growth is the priority, and macroeconomic policy support for demand in the near term continues to be vital. To ensure that growth is durable and robust, over the medium term the economy needs to rebalance, away from public support to private demand, and away from reliance on the domestic consumer to external demand.

2. The consultation focused on policies to secure strong and better balanced growth. This report responds to two basic questions: first, what is holding back the UK economy, and, second, what policies are needed to stimulate growth and promote the necessary rebalancing?

The Recovery Remains Weak

Activity is still sluggish, but recent developments are encouraging

3. Growth substantially disappointed in 2012. The UK economy grew by about ¼ percent in 2012. Net trade reduced growth by 0.6 percentage points of GDP, the biggest drag since 2005, and well above staff projections. Domestic fixed capital investment was essentially flat, leaving household spending the main source of private demand, but still substantially below long-run potential growth. In terms of production, construction has been particularly affected by the financial crisis, and the mining sector has been experiencing a secular decline, accelerated in part by temporary shut-downs in North Sea oil extraction. Output of financial services has gradually declined, such that its share of value added is now at levels of a decade ago. But the overall trend of weak growth cannot be exclusively attributed to these factors.

uA01fig01

Contributions to Growth

(Percent)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Haver Analytics;ONS; and IMF staff calculations.
uA01fig02

Gross Value-Added

(Index, 2007 = 100)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Haver Analytics; ONS; and IMF staff calculations.

4. Recent data suggest some improvement in economic conditions. Purchasing indicators, demand for vehicles, and consumer and business sentiment surveys indicate an uptick in activity (see Figure 1). In addition, there are signs that the drag from construction and trade might prove to be less than last year. And there have been some upward revisions to measured output that, although small, eliminated the “double dip” in growth. Coming after disappointing growth in 2012, such promising news is encouraging.

Figure 1.
Figure 1.

United Kingdom: Real Sector Developments

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Bank of England; British Chambers of Commerce; Office for National Statistics (ONS); and IMF staff calculations.1/ Bank of England Agents’ Survey, manufacturing.2/ Bank of England Agents’ Survey, services.3/ Gfk Consumer Confidence Barometer.

5. Financial market conditions also improved, but volatility has returned. Funding costs for banks and large firms had fallen significantly from the elevated levels seen during the summer of 2012. Equity markets had recovered strongly, with the FTSE All Share index nearly at the previous peak in April 2007, and prices of bank stocks rebounding. In May and June, markets have sold off, and conditions could remain volatile as markets seek direction about likely future returns and policy measures. Meanwhile, corporate bond issuance has been healthy, easing financing constraints for large firms. And the housing market is showing some signs of recovery, with house prices rebounding, reflecting a steady rise in the pace of new house orders and market transactions. Commercial real estate prices, however, remain depressed at levels last seen a decade ago, to the detriment of banks’ balance sheets and firms’ ability to borrow.

uA01fig03

Share Price Indices

(Index, Jan. 2008 = 100)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Datastream; Haver Analytics; and IMF staff calculations.
uA01fig04

ONS House Price Index

(NSA, Index 2008Q1 = 100)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: ONS; and IMF staff calculations

6. The labor market has performed somewhat better than the goods market (Figure 2). Employment is now slightly above its pre-crisis level, led by a notable change in the composition of the workforce—while public employment has declined by 4 percent (0.3 million workers) from its 2010 peak, private employment has increased by 5 percent (1.0 million workers) in the same period, most employment creation after 2007 is explained by a rise in part-time workers offset by a decline in fulltime workers. In addition, labor market participation has increased somewhat, because of changes in marginal tax and benefit incentives and older cohorts seeking to boost retirement savings.

Figure 2.
Figure 2.

United Kingdom: Labor Market Developments

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Haver Analytics; Office for National Statistics (ONS); and IMF staff calculations.1/ Estimates based on provisional data from the International Passenger Survey.
uA01fig05

Employment by Sector

(Index 2010Q1 = 100, SA)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: ONS; and IMF staff calculations.

Recovery will be protracted

7. But the UK economy remains a long way from a strong and sustainable recovery. Notwithstanding the recent uptick in activity, per capita income remains 6.5 percent below its pre-crisis peak, making this the weakest recovery in recent UK history. Even with the advantages of an independent monetary policy and a flexible exchange rate regime, output has been slow to recover. And GDP is well below the level implied by the pre-crisis trend—around 14 percent in real terms. Moreover, unemployment is still elevated, at 7.8 percent, while youth unemployment is 21 percent, higher than the OECD average.

uA01fig06

Recovery Relative to Previous Recessions

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

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: NIESR; ONS; and IMF staff calculations.
uA01fig07

Real GDP

(Index 2008Q1 = 100 at output peak; x-axis in quarters)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: WEO; and IMF staff calculations.
uA01fig08

Real GDP Growth

(Index, 1992Q1=100)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: ONS; and IMF staff calculations.
uA01fig09

Unemployment Rate

(Percent labor force)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Source: ONS.

8. Measured labor productivity growth has collapsed. With output growth so weak and employment relatively resilient, the growth rate of output per worker has plunged. No single explanation appears to fully explain the decrease in labor productivity growth, but it reflects, at least in part, a substitution of labor for capital, given the sharp decline in real wages, and a sectoral reallocation of labor towards less productive sectors (see Annex 1).

9. The output gap remains negative and large. The output gap is more-than-usually difficult to quantify. Some firms report increasing shortages of skilled labor, and some sectors (notably finance and construction) might still be in the process of returning to more sustainable levels of output.1 But still-high unemployment and weak wage growth points to an economy operating well below capacity. Staff estimates the gap to be just above 3 percent, broadly in line with other institutions’ estimates.2 The gap between the level implied by the pre-crisis trend and current output is larger than the output gap, implying that the estimated level of potential is some way below the trend line, but most of the shortfall in output is attributable to insufficient demand.

The economy is struggling to rebalance

10. A key factor in the weakness of the recovery is the struggle to rebalance. In the medium term, the economy needs to move away from public support toward private demand. Similarly, to ensure balanced growth, the economy also needs to rely more on external demand. Households and banks, however, currently face pressures to reduce leverage, while competitiveness problems and weak external demand are constraining external rebalancing. Hence, with the private sectors largely maintaining relatively high saving rates, the public sector consolidating, and weak export performance, the net effect in the short run is downward pressure on demand. In particular, while progress has been made in reducing the fiscal deficit, which not surprisingly has been a drag on demand, the private sector has been unable to take the baton from the government.

uA01fig10

Net Financial Transactions by Sector

(£ Billions)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: ONS; and IMF Staff calculations.
uA01fig11

Household Debt

(Percent of disposable income)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Bank of England; and Haver Analytics.

11. Limited progress in domestic demand rebalancing reflects household balance sheet impairment. Still-high household debt, diminished consumer confidence, and a squeeze of real incomes owing to high inflation have limited the recovery in private consumption. A crucial issue is how long the drag from household debt will remain. Monetary policy easing has substantially reduced the burden of debt servicing on household disposable incomes, to levels now below those in the boom years. And, as noted above, asset prices have been recovering overall. Yet it appears that the level of debt remains a significant constraint on spending for a sizeable proportion of households, especially given the uncertainty concerning future employment prospects. In aggregate, the ratio of household debt to disposable income has fallen by 26 percentage points (from 167 to 141 percent), but this level remains substantially above historical averages, suggesting that saving rates could remain elevated for perhaps 2 to 3 more years (see Annex 2).

12. Firms have added to saving pressure, at the expense of investment. Corporate balance sheets were relatively healthy overall going into the crisis, and corporate savings have increased further thereafter.3 Concomitantly, business investment has fallen substantially during the crisis: total investment as a share of GDP has fallen from 18 to 14 percent of GDP since 2007.4

uA01fig12

Investment

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Haver Analytics; and IMF staff calculations.
uA01fig13

Total Assets of UK-resident MFIs

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Bank of England; and IMF staff calculations.1/ UK (non-UK) exposures are proxied by sterling (foreign currency) assets.

13. The financial sector has also attempted to reduce leverage following the crisis. The Funding for Lending Scheme and European policy actions have reduced bank funding costs, mitigating emerging problems on the liabilities side of bank balance sheets (see Annex 5). But problems remain with poor asset quality (particularly associated with commercial real estate) and significant lender forbearance. Banks with such problems are reluctant to lend, especially to firms and households with poor collateral. Hence banks lie at the heart of the paradox of thrift—as weakness in the real economy persists, banks reduce leverage further, constraining lending and activity.

14. External rebalancing is being held back by competitiveness problems and other structural weaknesses, amplified by cyclical factors. Rebalancing toward export-led growth has been disappointing, especially given the 18 percent depreciation in sterling since the start of 2007.5 Limited progress in external rebalancing reflects structural weaknesses in the economy—including poor diversification of exports and export markets and a large reliance on financial services. This has been amplified by cyclical factors, including a decline in the terms of trade, weak external demand, and a lack of competitiveness (as indicated by relatively high unit labor costs), owing to a decline in productivity (see Annex 3). Previous historical episodes of external rebalancing in the UK and OECD countries have been associated with increases in labor productivity growth—suggesting that it will be difficult for the UK to improve its external balance unless there is an improvement in productivity and competitiveness.

uA01fig14

Goods and Services Export Market Shares

(Percent of world exports)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: IMF’s Direction of Trade Statistics; World Trade Organizaiton; and IMF staff calculations.
uA01fig15

Unit Labor Costs in G-7 Countries

(Index, 2000Q1 = 100)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Eurostat; and IMF staff calculations.

15. The exchange rate appears moderately overvalued. Staff estimates sterling to be overvalued by about 5–10 percent. After depreciating strongly in 2007 and 2008, sterling gradually appreciated (see Figure 3), and at the time of the 2012 Article IV consultation was assessed to be moderately overvalued. Since then, the nominal exchange rate has depreciated, but inflation in the UK has been higher than in trading partners, implying that a modest overvaluation remains. This assessment is broadly consistent with model-based estimates of medium-term fundamentals of the exchange rate and current account.6 A further depreciation of 5–10 percent would be consistent with narrowing the current account deficit from its current level of nearly 4 percent of GDP to a level consistent with medium-term fundamentals. However, although nominal exchange rate depreciation could facilitate a useful shift in the terms of trade, a durable restoration of competitiveness will require increasing productivity growth.

Figure 3.
Figure 3.

United Kingdom: External Sector Developments

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Haver Analytics; IMF’s International Financial Statistics; Office for National Statistics (ONS); and IMF staff calculations.

Outlook and Risks

Recovery will be gradual, with risks tilted to the downside

16. The economy is projected to recover slowly, under current policy settings. Staff expects growth of around 0.9 percent in 2013, and an annual average of about 1¾ percent over the medium-term. This projection assumes that the crisis in the euro area will not re-intensify, that overall external demand gradually strengthens, and that credit conditions will improve. Nonetheless, ongoing headwinds from fiscal consolidation, private-sector deleveraging, and depressed demand from the euro area and some emerging markets will limit the pace of recovery. Domestic demand is expected to continue to contribute to positive growth, while net trade, after acting as a small drag in 2013, makes a modest contribution to growth over the medium term (see Table 2).

Table 1.

United Kingdom: Selected Economic Indicators, 2009–13

article image
Sources: Bank of England; IMF’s International Finance Statistics; IMF’s Information Notic System; HM 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.

In percent of potential output.

2013: actual data through April.

Average. 2013: actual data through May.

Average. An increase denotes an appreciation. 2013: actual data through April.

Based on relative consumer prices.

Table 2.

United Kingdom: Medium-Term Scenario, 2012–18

(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.

17. The output gap is expected to remain substantial, raising the risk of hysteresis effects. With weak growth projected in the medium term, the output gap is projected to persist for several years, remaining around 2 percent in 2018, a profile similar to that projected by the Office for Budget Responsibility. The projection assumes that the negative output gap does not generate hysteresis effects on potential, which would imply less flexibility for loose monetary conditions and a larger structural fiscal deficit.7

uA01fig16

Real GDP Growth and Output Gap, 2013–2014

(Percent)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Source: IMF staff estimates.
Figure 4.
Figure 4.

United Kingdom: Price Developments

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Bank of England; Haver Analytics; Office for National Statistics (ONS); and IMF staff calculations.1/ Retail Price Index; contains cost of housing.

18. Headline inflation is high, but is expected to gradually decline to the 2 percent target. CPI inflation has remained stubbornly above the 2 percent target (currently 2.7 percent), owing largely to increases in administered and policy-driven prices (such as energy and tuition). But underlying inflation is modest—exempting administered prices, inflation is below the target, and nominal wage growth remains very weak. Inflation expectations do not indicate substantial risks to price stability: market-based expectations are in line with levels seen before the crisis, and survey-based expectations have fallen after having risen from 2009 to 2011. Although the impact of new administered price increases could take some time to work through, staff projects that headline inflation will fall below the target of 2 percent by 2017, assuming an unchanged monetary and fiscal policy stance.

uA01fig17

Inflation Measures

(Y/Y percent change)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Bank of England; and ONS.1/ Excludes energy, food, alcohol and tobacco.
uA01fig18

Inflation Expectations

(Percent)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Bank of England; and ONS.

19. Risks to the outlook remain to the downside.

  • The key risk is that persistent slow growth permanently damages medium-term growth prospects. This could arise if private sector deleveraging is larger than expected, credit conditions fail to improve, external demand does not pick up, and the drag from fiscal consolidation is greater than anticipated. Longer-than-anticipated weakness in aggregate demand could lead to further declines in investment in capital goods and human capital, implying lower growth for an extended period.

  • Risk remains that financial stress in the euro area re-emerges and there is a protracted period of slower growth. Despite recent market calm, growth in the euro area is likely to be weak, and the re-emergence of market tensions cannot be ruled out, with the potential for continued spillovers to the UK from depressed exports, higher bank losses and funding costs, and reduced confidence.

United Kingdom: Risk Assessment Matrix1

article image

The Risk Assessment Matrix shows events that could materially alter the central scenario, which is the scenario most likely to materialize in the view of the staff.

Policy Implications

A multi-pronged policy strategy is needed

20. Restoring growth momentum and rebalancing the economy is vital. Strong growth is needed to restore incomes, ensure the sustainability of public debt, and support bank balance sheets. For long-term prosperity and resilience against future shocks, the economy has to be diversified and not reliant on domestic consumption. These imperatives have supply as well as demand dimensions—after five years of relatively weak activity, additional measures are needed to raise long-term expectations of potential growth, while rebalancing necessitates a transformation to a high-investment and more export-oriented economy.

21. Policy remedies to restore growth and rebalance the economy are not straightforward. Monetary policy is effectively at the zero bound; banks’ health needs strengthening through building capital buffers, but in a way that does not reduce credit; and public debt is rising, but the consolidation to address this will be a drag on growth. This implies that no one policy lever will be sufficient; hence, there is a need for a coordinated multi-pronged strategy to guide the economy to greater and more balanced growth.

22. Appropriate policies could have important benefits for other economies as well as the UK. Simulations of a package of complementary and balanced policies—monetary and fiscal support for demand, including targeted expenditures on public investment, and structural reforms to raise productivity and the labor force—show that there are important potential gains to the UK and other countries. Importantly, although monetary easing is likely associated with sterling depreciation, the net demand effect dominates, and all economies experience increases in their own incomes, even if their exchange rates appreciate.8

Monetary and Credit Easing Policies

Notwithstanding bold action, transmission of monetary policy has been weak

23. Monetary policy in the UK has appropriately been highly accommodative. The Bank of England (BoE) has implemented a number of measures:

  • The BoE lowered the policy rate aggressively (currently at 0.5 percent), despite headline inflation being above target for an extended period.

  • From January 2009, the BoE has engaged in Quantitative Easing (now amounting to £375 billion, about ¼ of nominal GDP), bypassing the banking system to lower long-term rates and stimulate asset prices.

  • In July 2012, the BoE, jointly with Her Majesty’s Treasury (HMT), initiated the Funding for Lending Scheme (FLS), aimed at lowering funding costs for banks and boosting credit supply. In April 2013, the scheme’s duration was extended by one year, to January 2015, and its pricing structure modified to strengthen incentives for banks and nonbanks to lend to SMEs.

24. The March 2013 Budget provided a new remit for the Monetary Policy Committee (MPC). The remit reaffirms that the central objective of monetary policy is to meet the inflation target of 2 percent per year. It also clarifies the government’s expectations of the MPC about communicating the tradeoffs between inflation and growth, explicitly permits the use of unconventional policies, and requests the BoE to explore the use of thresholds to guide policy (see Box 2).

25. The transmission of monetary policy has, however, been weak.

  • Notwithstanding ample and cheap liquidity, the transmission to retail rates has only been partially successful. Mortgage rates have fallen considerably, lowering household debt servicing costs. However, spreads of other assets classes remain elevated or even higher than before the crisis, notably for lending to SMEs, as they are unable to post high-quality collateral as security.9

  • Despite a substantial increase in broad money (excluding intermediate other financial corporations), the transmission to lending has been unusually weak. Patterns in lending, rates and spreads, as well as surveys of lenders and borrowers indicate that demand and supply problems are both important in credit markets. Banks have endeavored to reduce leverage—while some non-core deleveraging has been desirable, credit more generally has also suffered, with reduced risk appetite particularly affecting riskier borrowers. But, just as importantly, borrowers have been deterred from drawing on credit by weak growth expectations and, anecdotally, increased caution about the stability of prospective relationships with banks. Firms have notably relied increasingly on retained earnings and built up unusually high levels of working capital, at a cost to investment (see Annex 4).

Maintain accommodation, but temper expectations of effectiveness

26. Monetary policy should remain accommodative. The continued underperformance of the economy, reflected in the persistent output gap, calls for the accommodative stance to be maintained for an extended period. Because underlying inflation pressures are expected to remain subdued, there is no immediate risk of the credibility of the monetary policy framework being eroded.10 A broad set of tools could be considered:

uA01fig19

Interest Rates

(Percent, January 2006-April 2013)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Source: Haver Analytics.
uA01fig20

M4 Lending by sectors

(Index, January 2008 = 100)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Haver Analytics; and IMF staff calculations.
  • QE. The BoE should consider further purchases of gilts. Studies by staff and at the BoE have found that quantitative easing has reduced yields on long maturity government bonds, with positive effects on asset prices. There is no clear evidence to suggest that the effectiveness of QE—in the narrow sense of affecting gilt prices and expanding broad money—has diminished over time. However, the transmission of broad money to credit has been weak (see ¶27 and Annex 4).

United Kingdom: Forward Guidance

The changes to the MPC’s remit raise the possibility of the BoE using explicit forward guidance on policy rates as a tool of monetary policy, potentially with explicit thresholds to signal when rates would be changed.

Forward guidance covers a range of possibilities. At one level, a central bank could be transparent about what it sees as the likely path of policy rates to achieve its policy target, based on its assessment of the current state of the economy. Another level would be to commit to a path for policy rates, whether for some period of time or guided by a limited number of threshold conditions (such as the level of unemployment or growth in a nominal variable such as incomes).

The case for greater transparency about future rates

Monetary policy transparency in the UK is relatively high, aided by a thorough explanation of views of the state of the economy in the quarterly Inflation Report. However, projections for inflation and output are conditioned on market expectations, and have to be “inverted” for private agents to infer the desired interest rate path. Currently, markets do not expect rates to rise until 2016. However, there is a potential risk that households and firms might anticipate that long interest rates increase faster than the Committee would desire, especially if other economies raise rates earlier. Greater transparency about future policy rates could therefore be a useful tool.

Forward guidance as demand stimulus

Another argument for forward guidance is that the promise of lower expected rates—whether by lower nominal rates or higher future inflation—would induce private agents to bring forward demand. This rests on some crucial assumptions: first, that private agents respond now to future interest rate reductions, and that they perceive the policy-maker’s promise to be credible. In a situation in which agents are credit constrained, as currently, the effectiveness of forward guidance will be reduced. Hence, as with other monetary policy tools, complementary financial policies to restore credit intermediation are needed for this mechanism to be fully effective.

Commitment and thresholds

The central bank could take forward guidance a step further by binding its own actions based on specific criteria. The bank could commit to keep rates at a certain level for a period of time, or until an economic condition(s) is satisfied (in the case of the Federal Reserve, until unemployment is below 6.5 percent and inflation remains anchored). The central bank needs to assess the disadvantages of tying its own hands and the benefits of making the promised rate path credible. Thresholds also need to be easily communicable—well-known, accurate and timely—while also a sufficiently broad to summarize the overall state of the economy. And any particular threshold would probably need to be supplemented with one or two other conditions—such as inflation and financial stability—to cope with unforeseen shocks.

  • Forward guidance. In a situation such as currently faced by the UK, assurance by the central bank that policy rates will be kept low as the economy reaches full momentum can play a useful role; however, it is unlikely that this by itself could instigate a recovery (see Box 2).

  • Purchase of private sector assets.11 The sizes of these markets are relatively small, because of which the broad money creation effect would be small. However, concomitantly, small purchases by the BoE could have a material impact on the prices of such assets. In the cases of covered bonds and securitized SME lending, a secure source of demand could play a useful role in making issuance of such instruments more viable.

  • Policy rate cut. In principle, the Bank rate could be cut further. However, with a large quantity of bank loans automatically linked to the policy rate, bank profitability could suffer, further inhibiting loan growth. Hence, such a step would need to be considered carefully.

  • Modifying the FLS. If draw-downs from the FLS and credit creation remain weak, authorities should examine whether current collateral requirements and haircuts (which are currently set to match the discount window rate) are appropriate

27. But the effectiveness of monetary policy is limited by weak banks and final demand, making support from financial and fiscal policies vital. The effectiveness of accommodative monetary policy is dependent on the health of the banking system and the demand for credit. Hence, implementation of financial policies to strengthen banks’ health and fiscal and structural measures to boost expectations of long-term incomes are necessary to give monetary policy greater traction. This is particularly important since private domestic deleveraging pressures (on both households and banks) have proven stronger than previously anticipated, and the response of net trade has disappointed.

Financial Sector Policies

Repairing bank balance sheets is crucial

28. Financial sector repair has advanced, aided by European and national policies. UK banks’ funding costs fell sharply following the EU Summit, OMT and FLS announcements in 2012Q3. Banks have also reduced their reliance on wholesale funding, taking advantage of the ample supply of deposits. Noncore deleveraging has progressed well, regulatory capital adequacy ratios continue to edge up, and profitability—which had been dented by large conduct costs in 2012—has improved somewhat in the first quarter of 2013 (see Box 3 and Figure 5).

Figure 5.
Figure 5.

United Kingdom: Selected Indicators for Major Banks

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: SNL and IMF staff estimates, for pre-impairment operating profit and impaired and delinquent loans; S&P, for conduct costs provisions; and Banks’ Pillar 3 disclosures for Core Tier 1 capital ratios (Basel III basis).1/ 2013 refers to Q1-2013.2/ For Barclays, Q1-2013 figures for pre-impairment operating profit, and 2012 figures for impaired and delinquest loans are not reported in SNL, so an extrapolation using changes in the numerator and denominator for each ratio was employed to derive estimates.3 Ratios shown for EU, UK and US banks with balance sheets above $1.5 trillion at end-2012 (Banco Santander did not disclose fully loaded ratios). The figures are as reported by banks in their Q1-2013 disclosures. Banks may apply different adjustments based on individual interpretation of Basel III requirements.4/Deutsche Bank has recently raised €2.96 billion of equity which would raise its ratio to 9.5 percent.

29. But banks are still not restored to healthy functionality. Significant asset quality problems linger on banks’ balance sheets: the share of non-performing loans is high, especially at the two government-intervened banks, and there are concerns about lender forbearance on commercial real estate and retail mortgage exposures.12 Moreover, the build-up of provisions and tangible capital—to buffer against these risks—has slowed since 2009. In general, the health indicators of UK banks are better than those of their EU peers, but markedly worse than those of US banks (see Figure 6). Finally, the outlook for profitability is depressed due to regulatory uncertainty about anticipated structural and price-based measures, and the impact of the new “conduct” environment on banks’ ability to pursue fee-yielding products. Against this backdrop, banks have been unwilling to expand lending to businesses, especially the riskier SMEs.

Figure 6.
Figure 6.

Comparison of Health of UK, EU and US Banks

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Bloomberg.; and IMF staff calculations. Ratios shown are not adjusted for accounting differences across regions (such as GAAP for US vs. IFRS for UK). UK refers to the average for HSBC, Barclays, RBS and LBG. EU and US indicators are weighted averages (by total assets) of the following major banks. EU banks: Cooperatieve Centrale Raiffeisen-Boerenleenbank, BNP Paribas, Credit Agricole, Societe Generale, Bayerische Landesbank, Commerzbank, Deutsche Bank, DZ Bank AG Deutsche Zentral-Genossenschaftsbank, LBBW, Credit Suisse Group, UBS, Banca Monte dei Paschi di Siena, Intesa Sanpaolo, UniCredit, Unione di Banche Italiane, Banco Bilbao Vizcaya Argentaria, Banco Popular Espanol, Banco Santander, Danske Bank, DNB, Nordea Bank, Skandinaviska Enskilda Banken, Svenska Handelsbanken and Swedbank. US banks: Bank of America, Bank of New York Mellon, BB&T, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, PNC Financial Services Group, State Street, SunTrust Banks. US Bancorp and Wells Fargo.1/ For US banks, FDIC series on commercial banks for “non-recurrent loans to total loans”, and “coverage ratio” were used as proxies for the NPA-to-total loans and loan loss reserves to NPA, respectively.

Strengthen capital position of banks and clarify strategy for state-intervened institutions

30. An expeditious repair of bank balance sheets is imperative for a durable resumption in lending. As discussed in the previous section, fully-functioning credit markets are crucial for monetary transmission. Moreover, the US post-crisis experience demonstrates well the benefits for credit markets and the economy of: (i) an early and comprehensive treatment of banks’ asset quality problems (including through adequate provisioning for expected losses); (ii) a focus on tangible capital-building; and (iii) credible stress tests, backed by supervisor-approved capital plans for major banks.

uA01fig21

Tangible Capital vs. Regulatory Capital Ratios, 2008-12

(Percent)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Bloomberg; and IMF staff calculations.

31. To this end, the authorities have recently conducted an Asset Quality Review (AQR) and laid out plans to strengthen banks’ capital positions.

  • Commissioned by the Financial Policy Committee (FPC, the macro-prudential authority), the March 2013 AQR determined that banks’ capital positions, as of end-2012, were overstated by £52 billion—this was attributed to under-provisioning for expected credit and trading book valuation losses (£30 billion) and conduct costs (£10 billion), and the overstatement of capital ratios resulting from an aggressive use of risk weights (£12 billion).

  • The estimated capital shortfall, however, is £27 billion when assessed against the FPC’s preferred end-2013 benchmark of a 7 percent fully-loaded Basel-III common equity tier 1 capital ratio, computed after making appropriate adjustments for expected loan losses and conduct costs over the next three-years, and for prudent risk weights.

  • The Prudential Regulation Authority (PRA) has announced the distribution of this shortfall across major banks (£13.6 billion for RBS, £8.6 billion for LBG, and £3 billion for Barclays) and has discussed individual banks’ capital-raising plans to meet the shortfall.13 The authorities have also announced their intention to launch system-wide stress tests, on an annual basis, from 2014 onward.

Financial Soundness Indicators for Major UK Banks1

(Percent)
article image
Source: Bloomberg. Indicators reported on a Basel-II basis.

Average for Barclays, HSBC, LBG and RBS.

32. It would be important to ensure that any capital building effort is robust, imparts certainty and preserves lending. While the AQR was an important stock-taking exercise, it was not a stress test and thus did not measure banks’ resilience to shocks. Moreover, the 7 percent capital benchmark ratio set by the FPC falls short of the 9½–10 percent level that will ultimately be required for major UK banks (as G-SIBs, or if within the proposed ring-fence), and that other global peers may already be targeting. In this context, and given the still-high leverage and euro area exposure of UK banks, the system-wide stress tests planned from 2014 should aim to cover a broad range of risks, employ sufficiently stringent scenarios, and aim for commensurately ambitious capital buffers. Transparency over methodology, results, and (supervisor-approved) bank-by-bank capital plans would significantly enhance the credibility of the stress tests. Finally, to protect credit, banks’ capital building effort, now and in the future, must focus on new equity issuance, reduction of dividend payouts, restrained remuneration, and balance sheet restructuring that does not reduce net lending. The FPC’s recent recommendation to the PRA that banks that are making satisfactory progress on capital should be allowed to reduce their liquidity coverage ratios to 80 percent (still well above EU minima) should also prove helpful in supporting credit during the capital-building phase.14

uA01fig22

Major UK banks’ Exposures to Euro Area Countries, end-2012 1/

(Percent of core Tier 1 capital) 2/

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Bank of England; EBA; and IMF staff calculations.1/ Banks included: Barclays, HSBC, LBG, and RBS.2/ Combined core tier 1 capital of Barclays, HSBC, LBG and RBS (on Basel-III basis).

33. A clear strategy is needed for the two government-intervened banks, with a view to returning them to good health and eventually private ownership. Together, RBS and LBG account for two-fifths of the stock of UK net private sector lending. The banks have made progress in repairing their balance sheets and improving profitability. But challenges remain, as evident by the recent inability as yet to divest branches, and the still-low market-to-book value for RBS.15 The approaching completion of the banks’ original EC-approved restructuring plans provides an opportunity to elaborate a clear way forward, especially for RBS where prospects are more uncertain and complexities greater. Any strategy should seek to return the banks to private hands in a way that maximizes the value for taxpayers, strengthens confidence and competition in the sector, and minimizes outward spillovers. In this context, if a sovereign backstop is required to meet a capital shortfall, it should be provided, as this would have a high multiplier in boosting growth.16

34. The authorities have recently announced their intended strategy for the state-intervened banks. The choice of a strategy is to be guided by the objectives of maximizing the banks’ ability to support the UK economy, maximizing the value for taxpayers, and returning the banks to private ownership. Consideration is being given to selling the government’s stake (39 percent) in LBG, possibly beginning with an institutional placement, followed by a retail offering. In the case of RBS, where the government has an 82 percent stake, a review is expected to be conducted by Fall 2013 (with external professional support) on the merits of a good bank/bad bank split that would allow the bank to focus on its core UK businesses and does not involve the bank’s nationalization. In this context, further public capital injections into RBS have been ruled out.

Fiscal Policy

Fiscal consolidation has been a drag on growth

35. Fiscal consolidation has been large and front-loaded, against a backdrop of large public deficits and debt. In mid-2010, the newly-elected government embarked on a large and front-loaded fiscal consolidation that aimed to balance the structural current budget by the end of a rolling 5-year window and put the net debt-to-GDP ratio on a downward path by FY15/16 (see Figure 7). To this end, the government set out a plan, comprising of discretionary deficit reduction measures of about £130 billion (8 percent of GDP) from FY 2010/11 to FY 2015/16. The government has since implemented more than a half of those discretionary measures. As a result, the overall deficit fell from 11 percent of GDP in FY2009/10 to 7¼ percent of GDP in FY2012/13.17 Over the same period, the structural deficit, as measured by the cyclically-adjusted primary balance (CAPB) as a share of potential GDP, narrowed by around 5 percent of GDP.

Figure 7.
Figure 7.

United Kingdom: Progress and Challenges in Fiscal Consolidation, 2009/10–2018/19

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: HMT; Office for National Statistics (ONS); and IMF staff estimates.
uA01fig23

Public Sector: Net Borrowing

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Source: HMT.1/ Excludes temporary effects of financial sector interventions and the transaction related to the transfer of assets from the Royal Mail Pension.
uA01fig24

Public Sector: Change in Cyclically Adjusted Primary Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Source: HMT.1/ Excludes temporary effects of financial sector interventions and the transaction related to the transfer of assets from the Royal Mail Pension.

36. While adhering to the medium-term framework, the government has shown welcome flexibility in its fiscal program. For instance, the pace of structural consolidation moderated in FY 2012/13, as the authorities decided appropriately in November 2011 not to make any discretionary adjustments to the path of consolidation in response to the OBR’s upward revision to the size of the structural deficit associated with its substantial downward revision of actual and potential near-term growth. Moreover, the government has allowed automatic stabilizers to operate freely, and, more recently, accommodated a slippage in meeting the Supplementary Debt Target—public sector net debt is now forecast to fall in 2017–18, two years later than set out in June 2010.

uA01fig25

Selected Countries - Changes in Cyclically Adjusted Primary Balances (CAPB) between 2009 and 2012 1/

(Percent of potential GDP)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: April 2013 WEO; and IMF staff estimates.1/ UK is on a fiscal year basis.

37. Despite flexibility, consolidation has hurt growth. The consolidation was the largest among major advanced economies, including France, Germany, Netherlands, Italy, Spain, and the US. Using a conservative multiplier estimate of 0.5 (just under the recent average of effective multipliers used by the OBR) would imply a cumulative GDP loss of 2½ percent, although it is plausible that the multipliers might be higher.

Bring forward growth initiatives while preserving the fiscal framework

38. Planned fiscal tightening in FY 2013/14 will be a further drag on growth. The March 2013 Budget envisages an additional discretionary tightening of £10 billion in FY 2013/14—in structural terms, the OBR estimates that these measures imply a reduction in the cyclically-adjusted primary balance of 1 percentage point of potential GDP. The discretionary tightening is smaller than in FY2012/13, but at a time when households, firms, and banks are all deleveraging and external demand is weak, the tightening will pose further headwinds to growth.

39. Judgments about fiscal policy need to balance debt sustainability with growth concerns. The combination of continuing weak growth and high debt presents a dilemma: further fiscal consolidation will weaken output, with the risk of a permanent loss to productive capacity, while debt will accumulate unless there is consolidation, with the risk of an eventual loss of credibility.

  • On the one hand, the UK has one of the highest deficit and debt levels in the G-20, and the latter continues to rise. With nominal growth projections revised down, and automatic stabilizers allowed to operate fully, the primary deficit is expected to remain above a debt-stabilizing level, contributing to a worsening debt outlook. Public sector net debt is expected to peak at just below 84 percent of GDP, and will begin to fall only in FY 2017/18 (see Appendix I on Debt Sustainability).

  • At the same time, however, weak growth has accentuated the large fiscal problem. In 2008-10, the rising debt was in large part accounted for by a worsening of the structural deficit, but more recently, it can be explained increasingly by unfavorable cyclical conditions. In particular, the impact of discretionary consolidation measures on deficit reduction has been more than offset by widening cyclical primary deficits—indeed, low growth is largely responsible for the worsening of the debt outlook.

  • Moreover, the drag from fiscal consolidation may be unusually large in the current situation. There is good reason to believe that multipliers—and the associated drag on output—are larger currently in the UK where the output gap is large, the economy is in a liquidity trap, and credit is constrained.

uA01fig26

Decomposition of Annual Changes in Gross Government Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Source: IMF staff estimates.
uA01fig27

Illustrative Alternative Scenario -Bringing Forward Capital Expenditure

(Real GDP growth in percent)

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Source: IMF staff projections.1/ Assumes £10 billion of planned capital projects will be brought forward from 2015/16 to 2013/14-2014/15.

40. On balance, therefore, given the tepid recovery, fiscal policy should capitalize on the nascent signs of momentum to bolster growth. This will need to involve pursuing measures that address both supply-side constraints and also provide near-term support for the economy. In the current context in which labor is underutilized and funding costs are cheap, the net returns from such measures are likely to be particularly favorable. The government has introduced some measures to support growth—in particular, it has altered corporate and personal income taxes, to boost investment and labor participation, and sought to switch from current to capital spending. However, these measures are generally too small in scale and, more importantly, some will not come into effect in the near-term. More can, therefore, be done now to support recovery.

41. Within the context of the medium-term fiscal framework, several growth-enhancing initiatives could be considered now to offset the drag from planned fiscal tightening. Such measures need to be aimed at raising expectations of long-run incomes and returns on investments:

  • Bringing forward planned capital investment where possible. This would help catalyze private investment and spur much-needed growth. The government’s National Infrastructure Plan identifies over 550 public and private projects, valued at around £310 billion. Although some projects, such as those requiring regulatory approval (e.g., energy sector projects) might be difficult to bring forward, other investment projects, such as roads, as well as social housing, could be brought forward relatively quickly. In addition, where projects are jointly-financed by the public and private sector, the government could consider raising its financial contributions, as the government’s borrowing costs currently are at a historic-low and much lower than those faced by the credit-constrained private sector.

  • Reducing business taxes. The corporate tax rate is expected to be reduced to 20 percent by 2015 (among the lowest in OECD). However, the level of the effective marginal tax rate will still remain relatively high, due to less generous capital allowances compared to other countries. Thus, there is room to reduce the effective rate. Furthermore, as recommended by the 2010 Mirlees Review, the government could consider introducing a tax allowance for corporate equity to reduce the tax incentive bias in favor of debt over equity finance and stimulate equity-financed investment. This measure would also help the financial sector raise capital as the cost of equity issuance would be decreased.

  • Offsetting the budgetary impact of these measures over the medium term. In particular, the government could consider broadening the VAT base and undertake a reform of property taxes. The standard rate of VAT was raised from 17.5 percent to 20 percent in January 2011, but many goods and services are zero-rated or exempt from VAT. Similarly, with respect to property taxes, council tax is levied on the value of property, but property valuations have not been updated since 1991 in the majority of the regions.

42. Government investment in supply-side measures to boost growth will enhance rather than damage credibility that the government has gained from its medium-term fiscal plan. The UK has a strong commitment to medium-term fiscal consolidation, an Office for Budget Responsibility that has rapidly established its credibility, and long-duration debt.

  • Market indicators for the UK—sovereign yields, CDS spreads, and sovereign default probabilities—have not signaled any credibility concerns; instead, these indicators have correlated well with other strong sovereigns, such as Germany (Figure 8). Raising growth expectations will do more for reassuring debt sustainability, while also supporting bank balance sheets. And although supply measures are often thought to have only long-run benefits, they could bring immediate reassurance to purchases of UK debt.

  • Moreover, given the exceptionally long maturity of UK sovereign debt—by far the highest in the G7, and a testimony to the authorities’ strong debt management capacity—even sharp changes in marginal yields would pass only slowly through to effective rates.

Figure 8.
Figure 8.

Sovereign Credibility

Citation: IMF Staff Country Reports 2013, 210; 10.5089/9781484385456.002.A001

Sources: Bank of England; Bloomberg;Datastream; Haver Analytics; IMF staff calculations.1/ Nominal yields minus inflation rates. The currency swap adjustments have not been made.

Housing Support Policies

New housing support measures pose risks

43. The government has introduced new policies to support the housing market. The 2013 Budget announced a new scheme, Help To Buy, aimed at boosting activity in the housing market and making it easier for first-time buyers to purchase homes. The scheme comprises two initiatives: an equity loan scheme (already implemented) and a mortgage guarantee scheme (still being finalized). The equity loan leg of the scheme is targeted to new builds, and the guarantee scheme will provide lenders with the option to purchase a government guarantee to compensate for a portion of losses in the event of foreclosure.

44. New housing market policies could boost aggregate demand, but also generate adverse effects. Momentum in the housing market is already growing, with support from falling mortgage rates (owing, in part, to the FLS). And the UK housing market is notable for inelastic supply and structural incentives that support housing demand (see Annex 6). Hence, there is a risk that the result would ultimately be mostly house price increases that would work against the aim of boosting access to housing. Moreover, the guarantees pose risks for the public balance sheet and create incentives for lower quality lending at a time when banks are being encouraged to boost the quality of their balance sheets.

45. The new measures require careful implementation. The scheme should be strictly temporary, both to alleviate financial stability risks and to help the economy rebalance away from a dependence on domestic consumption and non-tradable production. Moreover, the fee for banks to access the Help to Buy scheme should be set at a level commensurate with the risks posed to the public balance sheet.

46. The measures should be balanced by measures to address housing supply problems. Housing supply pressures could be eased by further liberalizing spatial planning laws. In particular, the planning system should be made more responsive to changes in demand. Housing supply could also be increased by making more land available for development through schemes that compensate those who stand to lose from new developments. To facilitate an adequate supply response, the government could also consider fiscal disincentives for holding land without development.

Structural Policies

A new wave of reforms is needed

47. Structural reforms are an essential complement to other policies. First, they are necessary to ensure a sustainable recovery to a dynamic economy—the current situation does not simply reflect a shortfall in aggregate demand, and reforms are needed to raise returns to investment and provide more confidence about long-term incomes. Second, reforms are necessary to aid rebalancing to a balanced and robust economy that is less dependent on specific sectors (e.g. financial services) and the buoyancy of domestic household spending.

48. A “second wave” of structural reforms is needed. The reforms implemented in the UK in the early 1980s induced more competition in goods and services markets, more flexibility in the labor market, and increased the share of working-age adults with higher education. However, structural weaknesses in human capital, infrastructure and innovation have undermined economic prospects. A number of initiatives identified by the LSE Growth Commission, the Heseltine Review, and the government should be pursued with greater vigor:

  • Improving skills: Retraining opportunities to currently low-skilled workers, including vocational training, would enable them make the transition to high valued-added, high wage work. Current immigration quotas can have perverse effects by restricting the attraction and retention of skilled workers (such as recent graduates).

  • Infrastructure: Investment in infrastructure, notably in transport and energy, could be supported by streamlining the planning application process and removing regulatory uncertainty. Devolving more authority over planning decisions to local authorities, with financial incentives provided through greater revenue sharing, could accelerate the implementation of infrastructure projects.

  • Banking: The banking sector in the UK is notably concentrated in comparison with other countries, with the six main retail lenders providing more than 80 percent of outstanding lending. Increased competition would better serve the needs of UK firms and households, especially given few alternative sources of funds for start-ups and smaller enterprises.18,19

Financial Regulation

Challenges posed by the new regulatory structure should be addressed

49. The UK has undertaken a major revamp of its financial regulatory structure. With the Financial Services Act (2012) coming into force on April 1, three new bodies have been formed: (i) the Prudential Regulation Authority (PRA), a subsidiary of the BoE, will be responsible for the regulation and supervision of most systemic institutions, including banks, building societies, credit unions, insurers and major investment firms; (ii) the Financial Conduct Authority (FCA), a separate institution not overseen by the BoE, will supervise and regulate other financial firms (e.g. non-banks such as asset managers), and be responsible for ensuring that relevant markets function well and for the conduct regulation of all financial firms; and (iii) the Financial Policy Committee (FPC), established under the purview of within the BoE, will oversee macroprudential policy.

50. The revamp of the financial regulatory structure is an important step, but comes with its share of challenges that will need to be addressed. The reforms of the regulatory and supervisory structure are aimed at improving the integration of microprudential and macroprudential supervision to safeguard financial stability. But important challenges remain:

  • Ensuring greater coordination across the regulatory bodies. In the context of a concentrated financial system, ensuring perfectly coordinated messages on bank capital while also respecting the lines of separation between macro- and micro-prudential policy is a challenge. This challenge was evident in the build-up to, and reactions to the publication of, the recent AQR, and could reemerge in the context of the multiple stress tests planned over the next 18 months—the PRA’s individual bank stress tests this year; the system-wide stress tests planned from 2014; and the EBA exercise expected in the second half of 2014. Given that banks already face significant regulatory uncertainty from anticipated structural and price based measures, there will be a premium on delivering consistent messages across regulators. However, this consistency must be secured in a way that does not compromise the operational independence of the PRA, which is critical for the effective supervision of the UK’s globally systemically-important financial institutions.

  • Maintaining the momentum toward an intensive and intrusive supervision model, supported by adequate resourcing. The UK’s new forward-looking and judgment-based supervisory approach—already supported by written documentation and strategies—is welcome. However significant further work and resources will be required for its full implementation. In particular, the PRA will need to overcome still-entrenched cultural barriers to adopting intensive and intrusive supervision, including by ensuring the data provided by firms is comprehensive, timely and accurate - a critical requirement for credible AQRs and bottom-up stress tests. There is also scope for more transparent communication of supervisory judgments about firms’ financial health and business models, and risk management and governance frameworks. Finally, it is important that recent progress on increasing senior management engagement in PRA’s supervisory decisions is complemented by a more formal framework for escalation of inspections, to help augment the integrity of the supervisory process.

  • Ensuring the independence of the FPC and equipping it with the right tools. The FPC’s independence should be guarded, including in the context of appointments to the Committee. Moreover, its tools should be augmented. The recent imposition of stricter forward-loss provisioning requirements on banks was an appropriate application by the FPC of its softer powers of recommendation. Augmenting the FPC’s harder powers of direction to include the authority to set the leverage ratio, with immediate effect rather than in 2018, and loan-to-value and loan-to-income ceilings would have important benefits. This is because the current toolkit, comprising sectoral and countercyclical capital requirements, is unlikely to be sufficient to effectively prevent a buildup of systemic risk, especially through property bubbles. Separately, it would be important for regulators to internalize the outward spillover effects that could arise from imposing higher capital requirements on globally-active banks headquartered in the UK. As discussed in Annex 7, these spillovers could be positive or negative, strong or mild, concentrated or dispersed, depending largely on the reaction function of global banks.

51. Structural banking reform measures will need to be coordinated internationally and address gaps. The effectiveness of the authorities’ planned (electrified) ring-fence atop price-based regulations to address systemic risk will depend in part on active cooperation at an international level on cross-border supervisory and bank resolution frameworks. The absence of such cooperation-including in the context of the envisaged banking union for the euro zone-could result in regulatory arbitrage, potentially undermining the UK’s attractiveness as a financial center. Moreover, while the envisaged ring-fence will improve the resolvability of banks inside the ring-fence, the issue of “too-important-to-fail” generally, and especially outside the ring-fence, needs further consideration. In this context, strengthening the regulator’s ability (and tools) to ex-ante discipline managers, shareholders, and debt holders can help reduce the buildup of risks in the first place. Finally, the implementation of the reforms needs to be pay attention to concerns about significant activity migration to more lightly-regulated shadow banks and non-banks.

The Authorities’ Views

52. The authorities broadly concurred with staff’s assessment of economic developments, noting that recent momentum, while encouraging, did not substantially alter the picture of a subdued and uneven recovery. Like staff, the OBR projects the output gap to remain persistently negative for a number of years. Both the OBR and BoE project modest growth for 2013 (around 1 percent), assuming that consumption would benefit from rising disposable incomes, reduced uncertainty, and continued easing in credit conditions. Net trade would remain vulnerable to the fortunes of the euro area, but was expected to be less of a drag on growth in 2013. Private fixed capital investment was expected to strengthen alongside consumption and exports. Authorities agreed that the performance of the euro area remained a significant risk, but put less emphasis than staff on the potential for stagnation and hysteresis.

Monetary and credit policies

53. With monetary policy already exceptionally loose, most members of the Monetary Policy Committee judged that no more stimulus was required at this time; some expressed concerns about inflation risks from further easing. Some members also cautioned that monetary policy could not raise income expectations, and had, in that sense, reached its limits. Most MPC members agreed that the ill-health of the banking sector played a significant role in reducing the effectiveness of loose monetary conditions. Many were of the view that credit demand was weak, owing to reduced confidence in future incomes and returns.

54. Authorities expressed satisfaction that the two main unconventional tools employed during the past 12 months—purchases of gilts and the Funding for Lending Scheme—were working mostly as anticipated. There were no obvious signs that QE had reached its limits in terms of the ability to affect yields on gilts. The FLS had played a role in bringing bank funding costs down and had reduced the cost of secured lending for households, but there was little evidence of a material effect on the cost of lending to SMEs (hence the recent modification to skew incentives towards SME lending). The authorities judged that no alterations to the range of acceptable collateral or the haircuts on collateral were needed at the current juncture. The authorities did not favor lowering Bank rate, as this, they viewed, would damage already-low bank profitability. MPC members expressed skepticism about purchases of private assets, arguing that wealth effects would be small and purchases would expose the BoE’s balance sheet to credit risk.

55. The authorities generally felt that the new remit was useful. The remit re-confirmed the inflation target and clarified flexibilities, including the use of unconventional policy tools. Bank staff viewed the explicit recognition of tradeoffs in part as a codification of existing practices, but also viewed it as a good opportunity to take steps toward greater transparency about such tradeoffs in the Inflation Report.

Fiscal policy

56. The authorities considered that the fiscal strategy has ensured a flexible response and that growth-enhancing fiscal policies have been put in place. Authorities cited large automatic stabilizers, switching from current to capital spending, and allowing the Supplementary Debt target to be relaxed, as well as specific growth-enhancing measures announced in the 2013 Budget. In addition, emphasis was placed on the ability of activist monetary policy to boost demand, especially under the terms of the new remit and the modifications to the FLS.

57. The authorities judged that any deviation from the announced plans for fiscal consolidation would be too risky. “Fine tuning” the consolidation path would bring little benefits in terms of growth (multipliers were not thought to be large) but may have large negative effects on credibility, with consequences for interest rates. Moreover, there were no signs of hysteresis effects and new data were taken as signaling that growth was picking up. For the authorities, continued fiscal vulnerabilities argued strongly in favor of maintaining existing deficit reduction plans.

58. The authorities agreed that the payoffs from infrastructure were substantial, but argued that there are substantial constraints to implementing significant additional public sector capital spending in the current year. The authorities argued that they continue to support public and private infrastructure investment, including by using the credibility of the Government balance sheet to encourage private sector investment through guarantees. However, at the same time, they emphasized the importance of ensuring overall value for money in any new public sector capital spending.

Financial sector policies

59. The authorities concurred with staff on the need for stronger capitalization of UK banks, and that it should be met by issuing new capital or restructuring balance sheets in a way that does not hinder lending to the economy. The authorities agreed on the importance of continuing the steps underway to strengthen the resilience of bank balance sheets. In this context, the authorities updated staff on progress by the PRA in implementing the FPC’s recommendation that major UK banks meet a common equity tier 1 capital ratio, on a Basel 3 basis, of at least 7 percent of risk-weighted assets by end 2013. In addition, they highlighted the safety benefits of building adequate capital buffers ahead of an eventual normalization of interest rates. The authorities assured that, while the precise scope has yet to be agreed, the system-wide stress tests planned from 2014 will be developed to cover a wide range of scenarios and risks, including macro-financial feedbacks, and seek to provide a model framework for testing and bolstering banks’ resilience to shocks.

60. The authorities agreed with staff’s call to return the two government-intervened banks to private hands in a manner that maximized taxpayer value, ensured financial stability, and improved credit intermediation. They noted that LBG was in good shape, and are actively considering options for the sale of the government’s 39 percent stake, although there is, as yet, no pre-determined timetable or method of disposal. RBS was considered more challenging, given its size, complex business model and global presence.

61. The authorities were alert to the challenge of coordinating micro- and macroprudential policies. The PRA agreed that ensuring its operational autonomy was a pre-requisite for supervision of the UK’s globally systemic banks and insurers according to statutory objectives. It also agreed that the verification of bank data needs further improvement, and that current resources don’t allow for a more detailed asset quality review. The interim FPC noted that it had decided not to recommend to the Government that the statutory FPC be given powers of Direction over LTV and LTI ratios at that time, on the basis that further analysis, reflection and public debate was necessary. Finally, the authorities appreciated the discussion on outward spillovers that may arise in the context of regulating global banks, but argued that such spillovers would likely be more positive.

62. The authorities concurred that the efficacy of UK structural banking reforms would partly depend on international progress on cross-border resolution and supervision. In this regard, they welcomed progress toward the establishment of a recovery and resolution directive in Europe. They also welcomed progress towards the single supervisory mechanism in the euro zone, while expressing satisfaction over the preservation of the UK’s voice within the EBA.

Staff Appraisal

63. Current policies are aimed at rebalancing the economy and anchoring durable recovery. Progress has been made in reducing fiscal risks and ensuring the sustainability of public debt. While adhering to the medium-term framework, the government has shown flexibility in its fiscal program to support the economy. At the same time, monetary policy has remained highly accommodative, to help support economic recovery, and has been complemented by innovative credit easing policies. This policy mix—tight fiscal and accommodative monetary and credit—is aimed at helping the economy rebalance from public to private and external demand led growth. Financial sector policies have been geared toward enhancing the resilience of the financial system, notably by improving the oversight framework and increasing the capacity to deal with systemically important financial institutions.

64. These policies have been broadly consistent with the Fund’s past surveillance advice. In particular, consistent with Fund advice, the government has accommodated a slowdown in the pace of structural fiscal consolidation, allowed automatic stabilizers to operate fully, and brought forward spending with high multipliers. Similarly, the BoE has kept monetary policy accommodative, including by additional purchases of gilts, and, jointly with the Treasury, introduced the Funding for Lending Scheme, aimed at lowering bank funding costs and improving credit conditions in the economy. Progress on financial sector reforms has also been consistent with FSAP recommendations.

65. Notwithstanding some nascent signs of growth, the UK is still a long way from a strong and sustainable recovery and unemployment is still too high. Activity is expected to pick up only gradually, as domestic deleveraging continues and external demand remains weak. Restoring strong and durable growth and rebalancing the economy, by addressing both demand and supply constraints, is vital to improving incomes, ensuring the sustainability of public debt, and returning the banking sector to good health. This implies the need for a coordinated multipronged strategy to guide the economy to greater and more balanced growth.

66. Monetary policy needs to remain accommodative. In addition to considering further purchases of gilts, the BoE could provide assurance to households and investors that policy rates will be kept low until the recovery reaches full momentum. These measures need to be complemented by credit easing schemes. In this context, the recent extensions to the FLS are welcome.

67. The effectiveness of monetary policy is, however, dependent on the health of the banking system. In particular, repairing bank balance sheets is imperative for a durable resumption of lending. This will involve, first and foremost, a strengthening of the capital position of banks. To this end, and as a follow-up to the AQR, banks should expeditiously meet their capital shortfall as assessed by the PRA. Moreover, beginning in 2014, it would be essential that the authorities conduct an annual stringent system-wide stress test, backed by supervisor-approved capital plans to ensure a robust level of bank capitalization. Most importantly, capital bolstering efforts should be based on a combination of new equity issuance, reducing dividend payments, restraining remuneration, and balance sheet restructuring that does not reduce net lending. A clear strategy is needed for the two state-intervened banks—which account for a large chunk of the stock of net bank lending—that seeks to maximize taxpayer value, strengthen the banks’ contribution to the economy, and eventually return them to private ownership. In this context, if a sovereign backstop is required to meet a capital shortfall, it should be provided, since this would have a high multiplier effect on growth.

68. It is essential that fiscal policy supports the nascent recovery. Planned near-term fiscal tightening will be a drag on growth, and will come on top of domestic deleveraging and a weak external outlook. Given the tepid recovery, it is essential that fiscal policy capitalizes on the nascent signs of momentum to bolster growth, by pursuing measures that would alleviate supply-side constraints and also provide support for the economy. In particular, to spur private demand, the drag from planned near-term fiscal tightening could be offset—notably by bringing forward capital investment and reducing business taxes—within the context of the medium-term fiscal framework.

69. The government needs to pursue with greater vigor structural reforms, aimed at rebalancing to a more dynamic, balanced and robust economy. In particular, measures aimed at improving the economy’s skills base and competitiveness would not only help boost the productive potential, they would help support demand in the near-term by boosting expectations about long-term prospects and incomes.

70. Financial stability needs to be bolstered by building on recent progress in improving the regulatory and supervisory structure. Such stability will anchor a strong and durable recovery and reduce the risk to taxpayers, as well as limit spillovers from shocks that are transmitted through the UK financial system. In particular, going forward, greater coordination between the FPC and the newly established PRA should be ensured, notably in the context of the planned bank stress tests, to alleviate regulatory uncertainty. The PRA should be adequately resourced and its operational independence ensured, to support an intensive and intrusive supervision of the UK’s globally-systemic financial sector. Similarly, the independence of the FPC should be guarded and its toolkit augmented, notably by allowing it to set leverage ratios beginning now, rather than in 2018, and providing it additional powers to limit loan-to-value and loan-to-income ratios, as higher capital requirements alone might be insufficient to restrain property bubbles.

71. Structural banking reforms should proceed apace, but the authorities will need to remain alert to challenges. The authorities’ intention to introduce an electrified ring-fence is welcome, but its effectiveness in reducing systemic risk without leading to a balkanization of capital will depend critically on progress, internationally, on cross-border regulation and supervisory frameworks (including in the context of the euro area banking union). The authorities should also ensure adequate and pro-active supervision of non-banks and shadow banks, given the possibility of significant risk migration to these entities due to regulatory arbitrage.

72. 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: Statement of Public Sector Operations, 2010/11–17/18 1/

(Percent of GDP, unless otherwise noted)

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

Excludes the temporary effects of financial sector interventions, 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 intervention.

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

March 2013 Budget estimates.

IMF staff projections based on March 2013 Budget expenditure plans and staff’s macroeconomic assumptions.

Table 4.

United Kingdom: Statement of General Government Operations, 2006–12

(Percent of GDP)

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Source: IMF’s International Finance Statistics.
Table 5.

United Kingdom: General Government Stock Positions, 2006–12

(Percent of GDP)

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Source: IMF’s International Finance Statistics.