Statement by Mr. Steve Field, Executive Director for United Kingdom, July 23, 2014

KEY ISSUESThe economy has rebounded strongly and prospects are promising. Headwinds thatpreviously held back the economy—relating notably to credit conditions andconfidence—have eased. Nonetheless, sustaining strong growth will depend on arecovery in productivity growth and further demand rebalancing. The housing marketbrings risks of financial vulnerabilities. Sterling is moderately overvalued.The overall policy mix is appropriate, but policy settings might need to be adjustedquickly. Effective monetary conditions are very supportive, compensating for ongoingfiscal consolidation:? Accommodative monetary policy is appropriate for now, given weak inflationpressures, but policy might need to be adjusted quickly if inflation takes off. Interestrate increases may also need to be considered if macroprudential tools areinsufficient to deal with financial stability risks from the housing market.? The authorities have recently implemented macroprudential measures, includinglimiting the share of high loan-to-income mortgages lenders can issue, establishingthem as the primary defense against housing-related risks. They should stand readyto tighten these limits should current settings prove ineffective in reining in thoserisks.? A lasting solution to house price pressures requires measures to address insufficientsupply. Significant planning reforms have been undertaken, but political consensus isneeded to make further progress in this area.? High deficits and rising debt mean that fiscal consolidation needs to continue. Thepace and composition of deficit reduction over the near term is appropriate. Furtherreducing the deficit over the medium term will be challenging; both revenue andexpenditure measures should be considered, keeping in mind both equity andefficiency.? The financial sector is more robust, the new financial architecture is settling in, andsignificant changes have been made to banks’ liquidity backstops to adapt tochanging needs. Implementing macroprudential policy will be a test of the newarchitecture. Some problems—such as Too Important To Fail and bank misconduct—persist, and new challenges, such as from shadow banking, are emerging.

Abstract

KEY ISSUESThe economy has rebounded strongly and prospects are promising. Headwinds thatpreviously held back the economy—relating notably to credit conditions andconfidence—have eased. Nonetheless, sustaining strong growth will depend on arecovery in productivity growth and further demand rebalancing. The housing marketbrings risks of financial vulnerabilities. Sterling is moderately overvalued.The overall policy mix is appropriate, but policy settings might need to be adjustedquickly. Effective monetary conditions are very supportive, compensating for ongoingfiscal consolidation:? Accommodative monetary policy is appropriate for now, given weak inflationpressures, but policy might need to be adjusted quickly if inflation takes off. Interestrate increases may also need to be considered if macroprudential tools areinsufficient to deal with financial stability risks from the housing market.? The authorities have recently implemented macroprudential measures, includinglimiting the share of high loan-to-income mortgages lenders can issue, establishingthem as the primary defense against housing-related risks. They should stand readyto tighten these limits should current settings prove ineffective in reining in thoserisks.? A lasting solution to house price pressures requires measures to address insufficientsupply. Significant planning reforms have been undertaken, but political consensus isneeded to make further progress in this area.? High deficits and rising debt mean that fiscal consolidation needs to continue. Thepace and composition of deficit reduction over the near term is appropriate. Furtherreducing the deficit over the medium term will be challenging; both revenue andexpenditure measures should be considered, keeping in mind both equity andefficiency.? The financial sector is more robust, the new financial architecture is settling in, andsignificant changes have been made to banks’ liquidity backstops to adapt tochanging needs. Implementing macroprudential policy will be a test of the newarchitecture. Some problems—such as Too Important To Fail and bank misconduct—persist, and new challenges, such as from shadow banking, are emerging.

I thank staff for a very productive mission and thorough Article IV report. My authorities broadly agree with the staff analysis, note that staff considers the overall policy mix appropriate and, notwithstanding the entrenched recovery, agree with staff that efforts should continue to ensure the UK is more resilient to ongoing domestic and external challenges.

Economic Outlook

The UK economy is moving into expansion with the composition of the economic recovery broadening and becoming more sustainable.

WEO projections show the UK is expected to grow at 3.2 per cent this year, faster than any other major advanced economy, and 2.7 per cent in 2015. GDP growth in Q1 was 0.8 per cent, the fourth consecutive quarter of growth around or above its pre-crisis average rate. Recent survey data for the services, construction and manufacturing sectors remains strong, pointing to growth continuing around these rates.

The recovery now appears more broad-based than previously estimated, with the pickup in growth in 2013 associated with an increase in both household consumption and business investment growth (with investment increasing 10.6 per cent over the year to the first quarter of 2014).

Sustained output growth has not yet been accompanied by a material pickup in productivity. Looking forward, the Bank of England’s Monetary Policy Committee (MPC) expects there will be a gradual recovery in productivity as demand strengthens and the economy recovers. The pickup in business investment gives some positive indications, but the rate of productivity growth over the next couple of years is unlikely to materially exceed pre-crisis rates. Nevertheless, this anticipated gradual improvement in supply capacity means that, on the basis of the current forecasts for demand growth, the absorption of slack is expected to slow over the forecast period compared with the recent past.

The employment picture has been positive. Over 1.5 million jobs have been created in less than three years. Unemployment has fallen from a peak of 8.4 per cent in 2011 to 6.5 per cent – its lowest level for over five years.

Over the same period, inflationary pressures have abated, with inflation falling from a peak of 5.2 per cent in 2011 to 1.9 per cent in June, close to the Bank’s 2 per cent inflation target. In June, the MPC judged that under market interest rate expectations, the economy remained on course to meet the 2 per cent inflation target and to eliminate spare capacity over the next two to three years.

The UK’s current account deficit is large by historical standards, at 4.5 per cent of nominal GDP in 2013. The recent widening primarily reflects the investment income surplus reversing to a deficit driven by falling profits abroad of UK firms. The MPC expects the trade deficit to be broadly stable over the next three years. The Office for Budget Responsibility’s (OBR) projections are consistent with a narrowing of the current account deficit to 1.5 per cent by 2018.

Whilst the global outlook is improving, ongoing domestic and external challenges remain. The Government’s strategy to promote a strong and sustainable recovery is built on: monetary activism; deficit reduction; structural reforms; and reform of the financial system.

Monetary activism

Monetary policy continues to play an important role in supporting the economy. Following the global financial crisis, the MPC reduced and held Bank Rate to its historically low level of 0.5 per cent and purchased a stock of assets amounting to £375 billion.

In last year’s Article IV the Fund recommended that reassurance could be provided that policy rates will remain low until the recovery reaches full momentum and noted that greater transparency about future policy rates could therefore be a useful tool. Consistent with this, in August 2013, the MPC provided guidance on the future stance of monetary policy, stating its intention not to raise Bank Rate at least until the unemployment rate fell to a threshold of 7 per cent, subject to maintaining price and financial stability. Unemployment has since fallen sharply as the recovery has gained momentum and fell below 7 per cent in April. Reflecting that good news, the MPC provided new guidance in February to make clear that when the MPC does start to raise Bank Rate, it expects to do so gradually, and to a level materially below its pre-crisis average.

Forward guidance has been a useful tool. Surveys of businesses to assess the effects of the initial phase of guidance found that the majority of companies consider policy guidance had made them more confident about UK economic prospects. On balance, companies indicated it had caused them to bring forward or increase spending and increase hiring. There was little reaction in financial markets to the transition between the two phases of policy guidance.

Macroprudential policies and the housing market

UK house price inflation has strengthened in line with the improved economic outlook, reflecting increasing demand for house purchases, which in turn has been supported by reduced economic uncertainty and improved credit conditions. UK house prices have increased by 10.5 per cent in the year to May 2014. Price increases have been most pronounced in London and the South East, while house prices excluding these regions have only increased by 6.4 per cent in the year to May. House prices in real terms remain around 5 per cent lower than they were in 2007. The Bank’s central view suggests annual house price inflation will continue at current levels until mid-2015, after which it is expected to slow and grow broadly in line with incomes from 2016.

Debt-servicing ratios have remained low, reflecting longer mortgage terms and low mortgage rates. The average gross debt-servicing ratio on new mortgage lending has been less than 19 per cent of borrowers’ incomes in recent quarters, lower than at any point since at least 2005. Loan to value (LTV) ratios on new mortgages have risen modestly, but remain below historical averages. More generally, housing market activity has shown early signs of a cooling since the start of the year. Most notably, mortgage approvals fell for the third consecutive month in April and were 17 per cent below the January 2014 peak.

Currently there is no imminent financial risk associated with the housing market, but there is a need to remain vigilant. Over the past year, house price inflation has begun to broaden geographically across the UK. The share of lending at higher loan to income (LTI) multiples on new lending for owner-occupier house purchase has increased. In the four quarters to 2014 Q1, around 10 per cent of lending for house purchase was extended at an LTI at or above four-and-a-half times income; this compares to 6.5 per cent in the immediate pre-crisis period, 2005–07. Continued growth in housing activity and sustained increases in house prices relative to incomes could to lead to further increases in the share of mortgages advanced at higher LTI multiples, increasing the proportion of highly indebted households. To guard against these risks the authorities have taken policy action.

The new Financial Policy Committee (FPC) in the Bank of England has been given the authority to act should housing market pressures represent a threat to the resilience of the UK financial system and economy. In June, the Government announced that the FPC would be given explicit powers of direction to limit the proportion of high LTI and LTV mortgages. The authorities had taken a number of measures before the Article IV mission: at the end of last year they refocused the Funding for Lending Scheme away from mortgages towards small business lending; earlier this year more rigorous mortgage standards were introduced; and a UK tailored stress test (part of the EU-wide stress test coordinated by the European Banking Authority (EBA)) will assess the resilience of system to a marked fall of 35 per cent in house prices and substantial increase in interest rates.

Since the mission, the FPC has announced two further measures to protect against the risk of a marked loosening in underwriting standards and a further significant rise in the number of highly indebted households. First, that when lenders are assessing applications for mortgages they test whether the mortgage would be affordable if the prevailing Bank Rate were to be 3 per cent higher than at loan origination. And second, that no more than 15 per cent of a lender’s flow of new mortgages should be at or above four-and-a-half times the borrower’s income.

The LTI ratio is not designed to bite now on the market as a whole, nor in the future, if the economy evolves in line with the Banks central forecasts. Rather it will only bind if pressures increase above current forecasts. In addition, most lenders are already testing whether borrowers could afford mortgages if interest rates were to rise by around 3 per cent, but the FPC’s recommendation is intended to stop that from slipping. Both measures would act to constrain risks if house prices grow more than we expect, incomes grow less, or underwriting standards slip. The FPC will keep these measures under review.

The fundamental problem, however, is that the growing demand for homes must be met by growing supply. The Government is committed to reforms to address the long term structural issues in the housing market, including increasing housing supply and reform of the planning system. At Budget 2014 the Government announced measures to support the building of over 200,000 new homes, including the extension of Help to Buy equity-loan scheme to March 2020. The Government has also introduced the National Planning Policy Framework (NPPF) that replaces the previous fragmented system with a unified framework. Planning approvals are now at their highest level since 2008 with 88 per cent of applications approved in Q4 2013 and 174,000 planning permissions granted in England in 2013, the highest annual figure since 2007.

Deficit reduction

The deficit is forecast to have fallen by a half as a percentage of GDP by 2014-15, but it will still be too high at 5.5 per cent. Faster growth alone will not balance the books. The OBR expects public sector net debt to be 74.5% of GDP this year and expects it to peak at 78.7% in 2015-16 – lower than the 80% previously forecast - before falling. General government gross debt is expected to peak at 93.1 per cent in 2015-16. Continued implementation of the government’s medium-term fiscal consolidation plan is necessary to tackle these high levels of public debt, which divert resources toward higher interest payments and away from public services, and increase the UK’s vulnerability to future shocks. The government welcomes the IMF’s judgment that the pace and composition of the deficit reduction in the near-term and the goal to eliminate the overall deficit by 2018-19 is appropriate.

The UK general election is scheduled for 7 May 2015 and as such detailed fiscal consolidation plans are only specified through 2015/16. Further savings will be required to support the government’s commitment to put the public finances on a sustainable path. The Chief Secretary to the Treasury has asked the Minster for the Cabinet Office to set out an ambitious new efficiency programme to deliver savings from 2016-17 and across the next Parliament.

The government’s fiscal consolidation plan envisaged a split of 80 - 20 between spending and tax. All the tax measures have been delivered. Efforts to drive efficiencies and reduce wasteful expenditure have already yielded savings of £20 billion a year compared to 2009-10. Spending Round 2013 identified a further £5 billion additional efficiency savings in 2015-16. At the same time significant reductions in overall departmental spending have been delivered while protecting education and health and maintaining broader public service outcomes.

To further manage spending pressures, the government has brought a material amount of spending under new controls through the introduction of the welfare cap. The welfare cap is a nominal spending limit for “welfare in scope” (state pension and counter-cyclical spending excluded) in each year of the forecast starting from 2015-16. The OBR will report annually on the government’s performance against the cap, starting in Autumn 2014. This is an important improvement in spending control and budget management.

As highlighted in the IMF’s analysis, the government publishes analysis at each fiscal event showing the breakdown of the cumulative impact of the fiscal policy changes on households by income distribution. The government is mindful of the distributional impacts of fiscal consolidation and the analysis shows that households in the top income quintile make the greatest contribution towards reducing the deficit, both in cash terms and as a percentage of their income and benefits in kind from public services.

In December 2013 the government announced a review of the current fiscal framework – in line with the objective to revisit the design of the fiscal framework once the public finances were closer to balance. The outcome of the review will inform an updated Charter for Budget Responsibility, which will be presented to Parliament alongside Autumn Statement 2014.

Structural reform

Structural reforms remain very high on the government’s agenda to rebalance and strengthen the economy. Particular focus has been placed on prioritising infrastructure investment. In this context, and as the IMF have recognised, the government has already taken a number of steps to switch current spending to capital spending to support the quality of the fiscal consolidation and long-term productivity growth. In June 2013, the government provided greater long-term certainty by setting out commitments for over £100bn of capital spending out to 2020-21.

The National Infrastructure Plan 2013 sets out a refreshed infrastructure pipeline of investment worth over £375 billion. The NIP also includes a provision of up to £40 billion of support for critical infrastructure projects through the UK Guarantees Scheme.

The government has also taken action to equip young people with the skills they need to compete in the labour market. At Budget 2014 the government expanded the Apprenticeship Grants for Employers scheme, by providing an extra £85 million in both 2014-15 and 2015-16 for over 100,000 grants to employers.

Reform of the Financial System

Delivering and completing necessary financial regulatory reforms and repair continues to be a priority, building on recent progress.

The new more focused architecture for judgment-led financial regulation and supervision has been up and running since April 2013. Since the crisis broke, banks in the UK and elsewhere have made significant progress in rebuilding capital. The FPC therefore decided in June to close its recommendation of March last year that the largest UK banks and building societies should meet a minimum 7 per cent Common Equity Tier One ratio (set out in the EU rules to implement Basel III) after adjustments for expected future losses, future conduct costs, and a more prudent calculation of risk weights. The capital adequacy framework has made much needed progress in recent years. The leverage ratio is a very useful complement, which is why the Prudential Regulation Authority has moved to using a baseline leverage ratio more rapidly than the international standard requires. The FPC is currently consulting on the scope and form of its application.

As part of this, further improvements to the quantity and quality of banks’ capital should bolster their resilience to unexpected shocks. Earlier this year, the EBA announced details of its 2014 stress-testing exercise. In addition, several UK banks and building societies will participate in a UK variant of the EBA’s stress test focusing on a housing shock. In combination, these measures can enhance the safety and soundness of firms and improve the resilience of the financial system as a whole by ensuring that institutions fund their activities with sufficient capital.

Many of the key pieces of structural banking reform have been agreed and are already in the process of being implemented. The Banking Reform Act, which received Royal Assent in December 2013, introduces significant structural and cultural changes to the banking system. This includes giving the government the power to require the ‘ring-fencing’ of the deposits of individuals and small businesses and the authorities power to ensure that banks are more able to absorb losses. In June, the Bank announced it would extend the scope of its liquidity facilities to the UK’s biggest broker dealers and to central counterparties. Progress also continues to implement the global financial reform agenda, including enhancing competition in the financial sector, with work towards policy agreement ongoing in areas like shadow banking and completing reforms to enhance cross-border resolution.

The government recently announced further steps to raise standards of conduct in the financial system with a joint review by the Treasury, the Bank and the Financial Conduct Authority (FCA) into the way wholesale financial markets operate. It builds upon the tough action the UK has already taken to tackle misconduct, including the work of the FCA to reform LIBOR and the Parliamentary Commission on Banking Standards which has led to a new legal regime for senior managers. Strong and successful financial services that set the highest standards are an essential part of building a resilient economy and ensuring the UK financial system remains a global public good.