United Kingdom: Staff Report for the 2015 Article IV Consultation

Considerable progress has been achieved in the post-crisis repair of the UK economy. Private-sector indebtedness has been reduced, the financial sector regulatory framework has been overhauled, the fiscal deficit has been cut in half, and the employment rate has reached a record high. With the output gap now nearly closed, growth is expected to average near its potential rate of around 21/4 percent over the medium term, with inflation rising slowly from its current low levels to the 2 percent target by end-2017. However, this benign baseline is subject to risks, including those related to potential shocks to global growth and asset prices, still-high levels of household debt, the elevated current account deficit, and the degree to which productivity growth will recover. Uncertainty associated with the outcome of the forthcoming referendum on EU membership could also weigh on the outlook. Continued efforts are needed to complete the post-crisis repair, promote growth, and further bolster resilience.

Abstract

Considerable progress has been achieved in the post-crisis repair of the UK economy. Private-sector indebtedness has been reduced, the financial sector regulatory framework has been overhauled, the fiscal deficit has been cut in half, and the employment rate has reached a record high. With the output gap now nearly closed, growth is expected to average near its potential rate of around 21/4 percent over the medium term, with inflation rising slowly from its current low levels to the 2 percent target by end-2017. However, this benign baseline is subject to risks, including those related to potential shocks to global growth and asset prices, still-high levels of household debt, the elevated current account deficit, and the degree to which productivity growth will recover. Uncertainty associated with the outcome of the forthcoming referendum on EU membership could also weigh on the outlook. Continued efforts are needed to complete the post-crisis repair, promote growth, and further bolster resilience.

Focus of the Consultation

1. Economic growth and reforms have assisted repair of the UK economy following the global financial crisis, but challenges remain. In recent years, the UK has experienced steady growth with low inflation. Considerable progress has been made in repairing public finances and private-sector balance sheets, and new fiscal frameworks and financial sector regulatory architecture have been adopted. Nonetheless, important challenges and vulnerabilities remain—for example, productivity growth is still well below pre-crisis levels; growth remains heavily dependent on domestic demand, with a wide current account deficit; and household debt levels and fiscal deficits are still high, despite progress in reducing them in recent years.

2. The UK economy and financial sector also remain heavily interconnected to the rest of the world. This is in general a source of major benefits via gains from trade, cooperation, increased ability to specialize and realize economies of scale, and diversification of risks. However, interconnectedness also implies that the UK is affected by global shocks and can also be a source of important outward spillovers.

3. Against this background, the consultation focused on the following issues:

  • What is the current state of the economic cycle in the UK and what factors have driven recent economic developments?

  • What is the outlook for growth, job creation, and inflation?

  • What are the main risks and impediments to strong and steady growth?

  • How can the UK’s macroeconomic and financial sector policies support growth and limit risks, both for the UK economy and globally?

Macroeconomic Context

In recent years the UK has enjoyed a robust economic recovery, led by private domestic demand. With the output gap now nearly closed, growth is projected to average near its potential rate over the medium term. Inflation, which is currently just above zero, is expected to rise slowly back to 2 percent as one-off deflationary effects from lower commodity prices and sterling appreciation gradually dissipate. The large current account deficit is also projected to narrow somewhat as returns on foreign investments revert closer to historical averages. However, this relatively benign baseline scenario is subject to large global and UK-specific risks.

A. Macroeconomic Developments and Outlook

4. The UK economy continues to grow steadily. Output expanded by about 2¼ percent in 2015, following a nearly 3 percent expansion in 2014. With recent upward revisions also to growth estimates for 2011–13, the UK’s post-crisis recovery path now looks similar to that of the US. The recovery has been led by private domestic demand, which has more than offset weak external demand and ongoing fiscal consolidation (Tables 12).

Table 1.

United Kingdom: Selected Economic Indicators, 2012–17

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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. There is a break in the series from 2014 on, reflecting the reclassification of housing associations as part of the public sector.

In percent of potential output.

Average. An increase denotes an appreciation.

Based on relative consumer prices.

Table 2.

United Kingdom: Medium-Term Scenario, 2012–19

(Percentage change, unless otherwise indicated)

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

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.

In percent of total household available resources.

5. Remaining economic slack is limited. Standard models suggest that the output gap is nearly closed, as the unemployment rate and capacity utilization have returned to pre-crisis levels (Figures 12).

Figure 1.
Figure 1.

United Kingdom: Recent Macroeconomic Developments

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Sources: Haver; ONS; World Economic Outlook; Bank of England; and IMF staff calculations.1/ Implied forward CPI inflation rate, 5 years ahead on inflation-indexed bonds, assuming RPI inflation exceeds CPI inflation by 1 percentage point.
Figure 2.
Figure 2.

United Kingdom: Indicators of Spare Capacity

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Sources: European Commission; Haver; ONS; and IMF staff calculations.1/ IMF staff estimate.2/ IMF staff estimate.3/ European Commission.
A01ufig1

UK: Real GDP per Working Age Population

(2009 Q2=100)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Source: Haver.

6. Productivity growth remains low, but has recently started to tick upward.

  • Productivity growth has been very weak during the recovery, averaging only 0.4 percent (annualized growth in output per hour worked) during 2010–14, well below the 2.2 percent productivity growth rate observed during the decade before the crisis.

  • This productivity slowdown likely reflects a combination of factors. Some of these may be structural, given the broad-based slowdown in productivity growth across advanced economies that predates the crisis, possibly reflecting changes in the nature of technological progress, increased difficulties in measuring it, and/or changes in the pace of knowledge-based capital accumulation, among other factors. However, part of the slowdown may also be cyclical and therefore temporary, reflecting factors such as the post-crisis impairment of credit markets inhibiting the flow of investment to more productive sectors (see the companion Selected Issues paper).

  • More recently, productivity growth has started to rise somewhat, reaching 1.3 percent (y/y) in the third quarter of 2015 (Figure 1).

7. Looking forward, staff expects steady economic growth to continue in 2016. Lower commodity import prices, higher global growth, buoyant residential and commercial real estate prices (which should encourage investment), and ongoing monetary policy accommodation are expected to support expansion, offsetting headwinds from a moderate acceleration of fiscal consolidation (Table 3). On balance, staff projects growth in 2016 to remain around 2.2 percent.

Table 3.

United Kingdom: Public Sector Operations, 2010/11–19/20 1/

(Percent of GDP; unless otherwise indicated)

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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. The data reflect the reclassification of housing associations as part of the public sector starting from 2014/15.

Includes depreciation.

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

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

8. Staff projects growth to average around 2.2 percent over the medium term, as well. This is based on the following assumptions:

  • labor productivity growth continues its recent acceleration, eventually reaching 1.7 percent, (Table 2), but does not fully revert to pre-crisis productivity growth rates, given the possible structural factors behind lower productivity growth mentioned above; and

  • employment growth slows to around 0.5 percent in the medium term; this projection assumes that (i) the population expands as projected by the Office for National Statistics (ONS), (ii) the employment rate for those age 16–64, which recently hit a record high, soon stabilizes, and (iii) the employment rate of those age 65+ continues to rise in line with the trend over the last decade, due to ongoing increases in longevity and the state pension age.

A01ufig2

UK: Employment Rate

(Percent, SA)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Source: Haver.

9. Inflationary pressures remain subdued.

  • As of December 2015, headline inflation was near a record low at 0.2 percent; core inflation was also subdued at 1.4 percent.

  • Low inflation partly reflects lower import prices due to (i) the 15 percent appreciation of the NEER between Spring 2013 and end-2015 and (ii) the large drop in commodity prices since mid-2014. However, domestic drivers of inflation have also been muted, with nominal private-sector wages growing by only 2.1 percent as of November 2015 (Figure 1). Even if productivity growth remains in the range of only 1 percent, this pace of wage growth would still be consistent with underlying inflation of only around 1.1 percent.

  • Consequently, markets do not expect the BoE to raise its policy rate (currently 0.5 percent) until 2017. Under this scenario, staff expects inflation to rise gradually to 2 percent by end-2017, as effects from past exchange rate appreciation and commodity price declines dissipate and assuming a gradual rise in wage growth in response to tighter labor markets.

B. External Assessment

10. The current account deficit has risen substantially in recent years, reaching 5.1 percent of GDP in 2014 (Table 6). The increase has been due almost entirely to a weaker income balance. Part of this decline could reflect structural factors, such as the UK’s increasingly favorable corporate tax rates attracting more inward FDI, thereby reducing the stock of net FDI and in turn the income derived from it (see the companion Selected Issues paper). However, part of the decline in the income balance may also be temporary, reflecting factors such as unusually low returns on British investments abroad, possibly due to relatively subdued growth in major investment destinations such as continental Europe. Indeed, as the growth differential between the UK and other advanced economies has narrowed over the last year, the current account deficit has started to decline, reaching 4.2 percent of GDP (sa) in the first three quarters of 2015 due to an improving income balance.

Table 4.

United Kingdom: General Government Operations, 2008–14

(Percent of GDP)

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

United Kingdom: General Government Stock Positions, 2008–14

(Percent of GDP)

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Source: IMF’s International Finance Statistics.
Table 6.

United Kingdom: Balance of Payments, 2012–19

(Percent of GDP)

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

11. However, the current account was wider than justified by fundamentals in 2015, and sterling appeared overvalued. For the full-year 2015, the current account is projected to be −4.1 percent of GDP. Adjusting for cyclical factors and temporary effects on the income balance yields an underlying cyclically adjusted balance of −2.8 percent of GDP (see Annex 1 and the companion Selected Issues paper). This compares to a current account norm of −0.3 percent of GDP, as estimated by the EBA model, implying a current account gap of −2.5 percent of GDP and sterling overvaluation of 11 percent. The EBA REER models provide a similar assessment, estimating overvaluation of 10–12 percent. Adding uncertainty around these estimates yields an estimated current account gap of −1.5 to −3.5 percent of GDP and REER overvaluation of 5–15 percent in 2015. Most of the estimated current account gap (1.3 percentage points) reflects the fiscal balance currently being looser than its optimal medium-term level.

UK: Estimated Exchange Rate Overvaluation under Different EBA Approaches

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Source: IMF staff calculation.

Adjusted for cyclical factors. Uses an elasticity of −0.23.

12. Several factors mitigate risks associated with the high current account deficit. First, financing of the deficit has shifted to somewhat more stable sources, such as FDI. Second, even if exchange rate overvaluation does unwind rapidly, the BoE’s well-established inflation-targeting framework should allow it to largely look-through the one-off effects on inflation, as the BoE did during 2010–12, thereby avoiding pro-cyclical tightening. Third, the currency composition of the NIIP helps act as an automatic stabilizer, as foreign assets have a higher foreign-currency component than do foreign liabilities, such that sterling depreciation automatically improves the NIIP and income flows via valuation effects.

13. That said, a smaller deficit would be preferable. A large deficit may indicate underlying imbalances, such as sub-optimally low public and private saving. More generally, the sheer size of the deficit—the largest among advanced economies in 2014—and its general usefulness as an early warning indicator suggests that the deficit should not be ignored completely. For example, although recent financing has been more stable, events could change market sentiment and trigger a shift in the composition and size of financial flows. Abrupt outflows could adversely affect domestic investment, with negative outward spillovers via cross-border linkages with foreign investors. An accumulation of substantial external imbalances would thus be best avoided, and policies that assist external adjustment could be helpful.

A01ufig3

UK: Current Account Balance, 2014

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Source: WEO.

C. Risks and Spillovers

14. The baseline scenario is subject to several risks. In the near term, risks to growth are somewhat tilted to the downside, taking into account also the downturn in global asset markets in early 2016. Specific risks are elaborated upon in the Risk Assessment Matrix (Annex 2) and include the following:

Globally originating risks

  • Global downturn. Weak global growth and/or sharp declines in global asset prices would depress near-term growth in the UK. For example, simulations suggest that the Global Asset Market Disruption scenario outlined in the IMF’s most recent Global Financial Stability Report would reduce output by 2.3 percent relative to the baseline scenario by 2017 (Annex 3).

  • China and emerging markets (EMs). A sharp slowdown in China and other EMs would likely have only limited effects via trade channels, as they account for only 4 and 13 percent of UK exports, respectively. However, financial sector linkages are somewhat stronger, with system-wide exposures to China and Hong Kong SAR equal to about 150 percent of system-wide CET1 in mid-2015. Nonetheless, the BoE’s stress tests released in December 2015 indicate that the UK banking system’s core functions can withstand a severe downturn in China and EMs along with lower growth in the euro area.

UK-specific risks

  • Medium-term productivity growth. Despite the recent pick up, productivity growth remains far below its historical average, and the degree to which it will recover over the medium term remains highly uncertain. If productivity growth is lower than expected, this would have large adverse implications for medium-term output and incomes.

  • Real estate market-related risks. Housing and mortgage markets have decelerated somewhat over the last year, and lenders have become more resilient. Nonetheless, house-price growth continues to outpace income growth, and household leverage remains high by historical standards. A leverage-driven re-acceleration of the market would further increase households and banks’ vulnerabilities to house-price, income, and interest-rate shocks. Commercial real estate prices also continue to rise rapidly, and a market correction could reduce business investment and tighten corporate credit constraints, given lower collateral values (see later sections for further details on real estate market developments).

  • Referendum on EU membership. The government is currently renegotiating the terms of the UK’s membership in the EU, seeking changes such as increased leeway to limit benefits for new immigrants and an opt-out for the UK from the objective of “ever closer union”. Following these negotiations, the government plans to put membership in the EU to a referendum as early as 2016 and no later than end-2017. Quantifying how a decision to leave the EU would affect the economy is difficult, given that (i) the terms of staying in the EU are still being negotiated and (ii) the nature of post-exit relations with the EU are unknown. However, analysts have raised concerns that the exit debate could bring a period of uncertainty that could weigh on investment.

UK: Growth and Output Gap Projections

(Percent)

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Sources: OBR; IMF staff projections.

Authorities’ views

15. The authorities broadly shared staff’s baseline outlook and list of key risks. The authorities expected steady growth to continue over the next few years. The independent Office for Budget Responsibility (OBR) and the BoE were both slightly more optimistic than staff on the degree to which productivity would recover over the medium term, resulting in somewhat higher growth projections, though the authorities agreed that uncertainty about productivity growth remained large and was a key risk. Staff’s external assessment was viewed as reasonable. However, the authorities noted that the external stock position remained relatively sound, not least because BoE analysis showed that it would still be positive if all external assets and liabilities were measured at market value.

Policies to Promote Growth and Stability

Significant economic adjustment and policy reforms have been achieved since the crisis, with policies since the last Article IV being largely in line with past staff advice (Annex 4). However, further efforts are needed to complete the repair process. In particular, monetary policy should remain on hold until inflationary pressures are clearer and to help offset headwinds from fiscal consolidation, which is needed to help rebuild buffers. Such a mix of tight fiscal and loose monetary should also assist external adjustment. Mortgage-related macroprudential policies may need to tighten if the recent moderation of housing-related risks does not continue, financial sector supervision and regulation should remain conservative and intrusive, and the structural reform agenda should be completed.

A01ufig4

General Government Deficit and Gross Debt, 2015

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Sources: WEO; and IMF staff projections.

A. Fiscal Policy

16. The authorities have achieved substantial fiscal consolidation over the last five years. The overall deficit has been halved, falling from 10 percent of GDP in FY09/10 to 5 percent of GDP in FY14/15. Nonetheless, both the deficit and debt ratio remain high relative to those in other advanced economies. Consolidation has been achieved primarily by spending restraint (Figure 3).

Figure 3.
Figure 3.

United Kingdom: Fiscal Developments

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Sources: National authorities; and IMF staff projections.

17. The authorities plan to continue gradual fiscal consolidation over the medium term.

  • The consolidation plan aims for gradual deficit reduction and an eventual surplus by FY19/20 (Figure 3, Table 3). As a result, the gross debt ratio is expected to decline steadily over the medium term (Annex 5).

  • Consolidation will continue to rely mostly on spending restraint, especially for certain departments (e.g., Communities and Local Government). Selected priority areas will remain protected, including spending on the National Health Service, which will continue to increase every year in real terms, and foreign development assistance, which will be maintained at 0.7 percent of gross national income. Key revenue measures include changes to social insurance contributions and to dividend tax.

  • Relative to the last pre-election budget (March 2015), the authorities’ latest fiscal plans as announced in the 2015 Autumn Statement envisage a smoother path of deficit reduction. Consolidation is also now based somewhat less on spending cuts than previously projected, partly due to revised revenue and interest expenditure projections and new revenue measures.

A01ufig5

UK: Changes in Primary Balance

(Percent of GDP, cumulative from FY2014)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Sources: National Authorities; and IMF staff calculations.
A01ufig6

UK: Pace of Fiscal Consolidation

(Change in cyclically adjusted primary balance, percent of GDP)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Sources: Office for Budget Responsibility; and IMF staff calculations.

18. The consolidation path is appropriate in the baseline scenario. Continued consolidation is needed to rebuild buffers, thereby allowing more aggressive countercyclical policy during the next recession. Such an approach should yield net gains, as fiscal multipliers are likely lower now than they will be during the next recession, given that the output gap is nearly closed and that monetary policy over the next few years would likely be tighter in the absence of fiscal consolidation. The policy mix of tight fiscal and accommodative monetary policies should also support external adjustment.

19. However, automatic stabilizers should be allowed to operate freely, and the fiscal path may need to be eased if growth slows markedly. The stabilizers should operate symmetrically in response to small deviations of a cyclical nature. In the event of an extended period of sluggish demand growth—for example, if private investment is less robust than projected in the baseline—the flexibility in the fiscal framework (see below) should also be used to modify the pace of structural adjustment. In addition, the envisaged reductions in some categories of expenditure remain sizable, and the government may need to show flexibility in finding alternative fiscal measures if anticipated spending efficiency gains fail to materialize.

20. Pro-growth and pro-stability aspects of the consolidation could be further strengthened. Specific reform options along these lines include the following:

  • Scaling back distortionary tax expenditures (e.g., nonstandard zero VAT rates) could improve efficiency, increase tax neutrality, and free up resources for other uses. Such uses could include higher spending on priority items such as infrastructure, given that needs in this area are still high despite recent increases in capital spending relative to previous projections. Such priority items could also be funded by phasing out the “triple-lock” for pensions, which guarantees that state pensions rise each year by the highest of CPI inflation, wage inflation, or 2.5 percent. This approach is costly, poorly targeted to those most in need, and inconsistent with international best practice, which is generally to maintain a constant real income in retirement via indexation only to the CPI.

  • Property tax reform, along the lines recommended in the Mirrlees Review, could help reduce vulnerabilities in the housing market by easing supply constraints. For example, rebalancing taxation away from transactions and towards property values could boost mobility and encourage more efficient use of the housing stock. Reducing council tax discounts for single-occupant properties could also increase the utilization of these properties (see companion Selected Issues paper).

  • Reducing the tax code’s bias toward debt could also promote financial stability. This could be achieved by, for example, adopting an Allowance for Corporate Equity, with offsetting changes in other corporate tax parameters to ensure revenue neutrality.

A01ufig7

UK: Net Acquisition of Nonfinancial Assets

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Source: IMF staff projections.

21. The fiscal framework has been revised. Consistent with the medium-term fiscal plans, the authorities have adopted a new fiscal rule requiring a budget surplus, starting in FY19/20, as long as rolling 4Q on 4Q GDP growth exceeds 1 percent. Once projected growth falls below 1 percent, the rule allows the government to run a deficit until conditions allow a return to surplus. The rule is not a strictly binding one (as, for example, if it were enshrined in a constitution), but instead effectively operates on a “comply or explain” basis, adding another degree of flexibility. The rule is supplemented by a target for public sector net debt to fall as a percent of GDP in every year to FY19/20.

22. The authorities recently announced plans to start producing a regular analysis of fiscal risks. In mid-2015, the government undertook a review of the OBR to reflect on lessons learned during its five years of existence. The review concluded that the OBR was functioning well, but made some recommendations to further strengthen its operations. One of the key recommendations was for the OBR to start preparing a new report on fiscal risks, as recommend by the IMF’s Fiscal Transparency Code. The OBR plans to produce the first such report within the next two years.

A01ufig8

UK: Real GDP Growth

(Percent; recessions shaded)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Sources: ONS; Haver; and IMF staff calculations.

Authorities’ views

23. The authorities viewed their fiscal plans as helping to bolster fiscal resilience and improve public-sector efficiency. They emphasized that responsible fiscal policy should rebuild buffers to allow for the fact that the UK economy will continue to be hit by shocks in the future. They agreed with the need to maintain flexibility in the event of large shocks, but noted that the new fiscal framework covered most contingencies in this regard, as UK growth has exhibited a “bi-modal” tendency in which it has been either relatively strong (e.g., growth above 2¼ percent) or sufficiently weak that it would trigger the 1 percent escape clause (see text chart). The authorities stressed that the composition of consolidation aimed to support a competitive low-tax economic environment and prioritize efficiency gains, while continuing to provide high-quality outputs in key areas such as science, infrastructure, education, and health. In this regard, they emphasized that the pace of real cuts in departmental spending was significantly slower than in the previous parliament.

B. Monetary Policy

24. Monetary conditions remain accommodative. Current monetary policy settings—a policy rate of 0.5 percent and QE assets of £375 billion—have remained unchanged since the last Article IV consultation.

25. Monetary policy should stay on hold until inflationary pressures are clearer.

  • Both headline and core inflation are well below target. Forward-looking indicators—such as inflation expectations and wage growth in excess of productivity growth—are also well-contained (Figure 1).

  • While the output gap is nearly closed, continued monetary policy accommodation is likely to be needed to keep the output gap from re-opening, given the moderate acceleration of fiscal consolidation.

  • Moreover, risks to policy errors are asymmetric, as the costs to inflation undershooting likely exceed those of overshooting due to the increased complications related to easing monetary policy when interest rates are near the effective lower bound (ELB). In this regard, some moderate overshooting of the 2 percent target may even be desirable to more firmly escape the ELB.

  • Current monetary policy settings thus remain appropriate until inflationary pressures become stronger. However, policy should also stay data dependent and may need to adjust quickly if conditions change, especially if core inflation or wage growth in excess of productivity growth rises quickly.

A01ufig9

UK: Real Yields on Government Securities 1/

(Percent)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

1/ Real yields based on retail price index inflation, which tends to run somewhat higher than CPI inflation.Source: Haver.

26. The medium-term neutral real rate is likely to be lower than before the crisis. Market expectations of future interest rates, as indicated by long-term bond yields, have fallen sharply over the last two decades, likely reflecting high global savings and lower potential growth due to slower population growth, among other factors.

27. A lower neutral rate has at least two important implications.

  • First, it implies that the current policy rate may not be providing as much monetary stimulus as it may initially appear. This in turn may partly explain why inflationary pressures remain modest despite a nearly closed output gap and further underscores the case for keeping rates on hold.

  • Second, a lower neutral rate implies that the odds of hitting the ELB will be higher going forward than in the past. Consequently, contingency planning for addressing ELB-related problems that may arise again over the longer run is welcome. Such planning could include, for example, ensuring that the financial sector’s IT systems and legal contracts can incorporate negative interest rates, among other issues.

Authorities’ views

28. Monetary policy settings were viewed as appropriate. When the MPC judges it appropriate to raise Bank Rate, careful communication will be important to ensure a smooth lift-off. The BoE reiterated that the process of normalizing monetary policy should begin with rises in Bank Rate and proceed gradually—with the neutral rate likely to remain below levels seen prior to the financial crisis—and that QE asset sales should only be considered once Bank Rate had reached a level from which it could be cut materially in the face of a negative shock.

C. Financial Sector Policies

29. The UK’s banking sector has become more resilient in recent years in line with tougher regulatory requirements.

A01ufig10

European G-SIBs: CET1 and Leverage Ratios, 2015:Q3

(Percent; selected UK banks in red 1/)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

1/ UK banks include Barclays, LBG, RBS, and HSBC.Source: SNL
  • Capital. In preparation for the full implementation of Basel III in January 2019, UK banks have steadily strengthened their capital positions (text table). In aggregate, the ratio of common equity Tier 1 (CET1) capital to risk-weighted assets for major UK banks reached 12.0 percent in September 2015—up from 7.2 percent in 2011 and well above regulatory minima.1 Effective January 2016, the major UK banks must also satisfy leverage ratio requirements. The aggregate Basel III leverage ratio for major banks reached 4.7 percent in September 2015, also well above regulatory minima. The capital ratios of major UK banks were also broadly in line with those of their peers in other advanced economies.

  • Asset quality. Stronger capital positions have been supported by improving asset quality, with the non-performing loan ratio falling to 1.8 percent at end-2014—less than half its post-crisis peak (text table, Figure 4). Since the global financial crisis, UK banks have shifted the composition of their loan portfolios towards domestic lending and away from foreign lending and reduced their direct credit exposures to both other banks and nonbank financial institutions, lowering their interconnectedness.

  • Profitability. Profitability, however, remains low relative to historic levels. In aggregate, UK banks currently generate a return on assets about half that prior to the global financial crisis (text table, Figure 4). In parallel, the shares of the major UK banks now trade at around their book value, about half the multiple prior to the global financial crisis. The weak profitability of UK banks in recent years has been driven by lower trading income, lower net interest income, and high misconduct costs.

  • Liquidity. UK banks have strengthened their liquidity positions, with most major banks disclosing that they have already satisfied the full Basel III end-point liquidity coverage ratio requirement of 100 percent. Banks have also reduced their reliance on short-term wholesale funding while increasing deposits (text table, Figure 4), raising the overall stability of their funding.

Figure 4.
Figure 4.

Comparison of UK, EU, and US Banks

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Sources: Bloomberg.; and IMF staff calculations.Note: 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, State Street Corp., SunTrust Banks 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.

Financial Soundness Indicators for Major UK Banks 1/

(Percent)

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Sources: BoE FPC Core Indicators, IMF Financial Soundness Indicators.

The coverage of banks is as defined in the BoE’s December Financial Stability Report, except for asset quality indicators, for which the coverage is as defined in the IMF’s Financial Soundness Indicators.

2015 latest available data.

30. The government still has ownership stakes in Lloyds Banking Group (LBG) and the Royal Bank of Scotland (RBS), as legacies from crisis bailouts. With a business model focused on UK mortgage lending, LBG has benefited from robust UK growth. The government plans to divest its remaining ownership stake of less than 10 percent in the near future as market conditions allow. In contrast, RBS remains in the midst of a major restructuring and deleveraging, designed to simplify its business model and make it more domestically oriented. The government plans to divest at least three-quarters of its 73 percent ownership stake gradually over the course of this parliament.

31. The banking sector’s resilience to shocks is now regularly assessed by stress tests.

  • The 2015 stress test scenario featured a deep global macroeconomic downturn accompanied by an abrupt tightening of financial conditions, concentrated in China and the Euro Area. The test also incorporated severe but plausible future misconduct costs. The results, released in December 2015, indicate that all seven major UK banks—which collectively account for over 80 percent of domestic bank credit provision to the domestic economy—have the capacity to maintain lending under such a scenario, given their capital plans, including actions taken in 2015 (e.g., Standard Chartered announced in November 2015 that it planned to raise $5.1 billion in shares and cut 15,000 jobs).

  • Beginning in 2016, the BoE plans to conduct two banking sector stress tests per year, combining an annual cyclical scenario—the severity of which will vary with the financial cycle—with a biennial exploratory scenario designed to probe resilience to other risks in between the biennial European Banking Authority stress tests. Going forward, the integration of systemically important nonbank financial institutions, such as central counterparties (CCPs), into the stress-testing framework should be a priority.

32. Balance sheet repair has helped shift aggregate bank credit growth back into slightly positive territory, supporting economic activity. Going forward, bank credit growth is expected to converge gradually toward nominal GDP growth rates, now that the bank credit-to-GDP ratio has returned near pre-boom levels (i.e., circa 2000).

A01ufig11

UK: Lending Growth 1/

(Y-o-y percent change)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Source: Haver.1/ Lending by monetary financial institutions.
A01ufig12

UK: Outstanding Credit to Households and NFCs 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Source: Bank of England.1/ Lending by monetary financial institutions.

33. As the credit cycle shifts and the new regulatory architecture sets in, continuation of an intrusive and conservative approach to supervision and regulation will be essential. UK financial sector stability is essential not only for domestic macro-stability, but also to avoid adverse outward spillovers to the rest of the world, given the UK’s role as a global financial center. Priorities for reducing risks include the following:

  • Addressing emerging risks early. Given its central coordinating role in maintaining financial stability, the Financial Policy Committee (FPC) needs to continue scanning the horizon for emerging systemic risks, while taking action in concert with the Prudential Regulation Authority and the Financial Conduct Authority to remove or reduce them. In this context, the authorities should, in addition to their ongoing monitoring of large financial institutions, continue to monitor systemic risk arising from small and medium-sized financial institutions—which tend to have correlated business models—through robust thematic microprudential supervision. Also, the authorities’ recent efforts to push banks to bolster resilience to cyber attacks are welcome.

  • Countercyclical capital buffer (CCB). As the incipient financial cycle upturn in the UK gains momentum, the FPC should raise the CCB from its current level of 0 percent and continue raising it as warranted by credit conditions. While this is unlikely to significantly moderate the financial cycle, it will enhance the resilience of the banking sector in line with the level of systemic risk it faces. In this regard, the FPC indicated in November 2015 that a hike in the near future was likely, though any initial increase in the CCB would likely be at least partly offset by reductions in existing buffers, such that the first CCB hikes would probably not add to total capital requirements for individual banks, but rather increase the transparency of the nature of these buffers.

  • Risk weights. Supervisors should also continue to carefully scrutinize risk weights in banks’ internal models, including to ensure that they are not overly pro-cyclical. Although the leverage ratio requirement helps mitigate risks associated with internal models, heavy reliance on the leverage ratio as the binding capital adequacy constraint could incentivize banks to adopt excessively risky lending behavior. In this context, recently announced plans by the Basel Committee—in which the UK plays an important role—to complete work to address the problem of excessive variability in risk weights by end-2016 are welcome. Should the authorities identify immediate risks, the imposition of sectoral risk-weight floors and heightened risk-weight disclosure requirements should also be considered.

A01ufig13

UK: Average Risk Weights

(Percent)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Source: Bank of England.

34. A comprehensive set of arrangements to support bank resolution is being established. The UK regulatory framework includes three main elements relevant to resolution:

  • Ring-fencing. Effective January 2019, the major UK banks will be required to ring-fence their core retail operations, insulating them from risks arising in their investment banking arms. The Prudential Regulation Authority plans to complete its consultation process and publish final ring-fencing rules well before January 2019, to give banks sufficient time to implement them.

  • Total loss-absorbing capacity (TLAC). The Financial Stability Board recently finalized a TLAC standard for global systemically-important banks (G-SIBs)—of which the UK is the home jurisdiction for four—designed to ensure that they have sufficient equity plus eligible liabilities to absorb losses and be recapitalized in resolution. Consistent with the EU’s Bank Recovery and Resolution Directive, the BoE plans to impose a minimum requirement for own funds and eligible liabilities (MREL) on all UK banks that will apply as of January 2019 for G-SIBs and January 2020 for other banks. For UK G-SIBs, MREL will be set so as to implement the FSB’s TLAC standard.

  • Resolution planning. The BoE conducts resolution planning for all UK banks, which will be required to remove any substantive barriers identified to implementing the BoE’s preferred resolution strategy. Discussions are also ongoing with other jurisdictions on the issue of clarifying modalities for cross-border resolution.

These complementary requirements aim to mitigate the too-big-to-fail problem by (i) reducing the likelihood of a systemic banking crisis by subjecting the major banks to greater market discipline through their funding costs and (ii) reducing the macroeconomic costs of a major bank failure by facilitating orderly resolution while insulating taxpayers from losses.

35. It will be equally important to continue closely monitoring risks in nonbanks.

  • Nonbank financial institutions now account for nearly 50 percent of UK financial sector assets, up from less than 40 percent prior to the global financial crisis. This expansion has been concentrated among broker-dealers, pension funds, and investment funds. The resilience of broker-dealers continues to improve, with their leverage ratios having roughly doubled since the global financial crisis. Nevertheless, it is important that the FPC continue to assess the adequacy of the regulatory perimeter to guard against the migration of financial stability risks outside of it.

  • Another priority is to ensure that UK insurers are resilient to the low interest-rate environment. Although insurers’ assets and liabilities have well-matched durations, the low interest-rate environment has steadily eroded their investment income as maturing assets have been reinvested in lower-yielding securities. Nevertheless, UK insurers are sufficiently capitalized to withstand the stresses specified by Solvency II, which came into force in January 2016.

  • The ongoing FSAP, which is due to be completed in mid-2016, will be an opportunity to further assess the adequacy of steps taken to reduce risks in nonbanks, as well as to review broader changes (e.g., the liquidity framework) to the financial sector framework since the last FSAP in 2011.

36. The reform of ethics and conduct in the financial sector is ongoing. Financial institutions in the UK have been charged substantial misconduct costs, and the restoration of public trust in the ethical underpinnings of the financial sector remains elusive. The UK authorities are strengthening incentives for financial institutions to provide financial services in an ethical manner, in part by pushing accountability for misconduct down to the individual level, including via new measures such as the Senior Managers Regime, which increases the responsibility of managers for misconduct that occurs on their watch. Applying effective, proportionate, and dissuasive sanctions for misconduct, including for AML/CFT violations, should enhance compliance and promote financial integrity. The authorities’ efforts to promote global standards for the ethical provision of financial services are welcome.

Authorities’ Views

37. Post-crisis reforms were viewed as having bolstered financial sector resilience, though challenges remain. The FPC judged that, on a system-wide basis, significant further capital-raising was unlikely to be required. As a result, it foresees the sector transitioning to a more neutral phase of the cycle in which credit growth is more able to support sustainable growth. At the same time, newer risks, such as those related to cyber-security and expansion of the nonbank financial sector, were gaining prominence and warranted close attention. On mortgage risk weights, the BoE agreed that in some cases these were too pro-cyclical, but emphasized that leverage ratio requirements, stress testing, and hypothetical portfolio exercises provided mitigating backstops, as did measures under Pillar II of the Basel framework.

D. Real Estate Markets and Related Macroprudential Policies

38. Housing markets have decelerated somewhat since mid-2014, but significant pressures remain.

  • House-price growth has eased from 12 percent (y/y) in mid-2014 to around 8 percent in late 2015. The percentage of new mortgages with high loan-to-value or high loan-to-income ratios has also declined (Figure 5). This moderate deceleration of housing and mortgage markets may partly reflect policy actions, including tougher mortgage lending requirements (the FCA’s Mortgage Market Review) and an FPC restriction that no more than 15 percent of a lender’s new mortgages be at or above a loan-to-income ratio of 4.5. Though the latter restriction was not binding for the vast majority of lenders, it may have had a signaling effect that prompted them to reduce high loan-to-income mortgages.2

  • Despite the recent slowdown, house prices are still rising faster than incomes. Consequently, the average price-to-income ratio is climbing back toward its pre-crisis peak and has exceeded it in London (Figure 5).

Figure 5.
Figure 5.

United Kingdom: Housing Market Developments

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Sources: Haver; and IMF staff calculations.
A01ufig14

UK: House Price Metrics 1/

(Percent)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Sources: OECD; and IMF staff calculations.1/ Percentage deviations of the price-to-income and price-to-rent ratio s from their long-run historical averages (calculated from 1987Q1).

39. Persistent upward pressure on house prices partly reflects supply constraints. Restrictive planning regulations have long constrained supply, such that even the house-price boom of the early 2000s was not accompanied by the type of building surge seen in other countries such as Ireland and Spain. In addition, the crisis-induced shock to the construction industry has further constrained supply since 2008. Large builders consolidated and reduced employment, including of skilled workers, who are difficult to rehire quickly. Several smaller builders exited the market, and some remaining ones have seen their financing conditions worsen. Together, these factors have helped prevent housing completions from keeping pace with new household formation since 2008. The rapid rise in house prices in recent years without an accompanying surge in net mortgage lending (Figure 5) further points to supply constraints as an important driver of the increase in prices.

A01ufig15

UK: Household Formation vs. Housing Construction

(Thousands)

Citation: IMF Staff Country Reports 2016, 057; 10.5089/9781498367042.002.A001

Source: Haver.

40. High house prices result in some households taking on high leverage, posing financial stability risks. Despite recent declines, the percentage of new mortgages at high LTI ratios remains well above pre-boom (i.e., circa 2000) levels, as does the aggregate household debt-to-income ratio, which has stopped declining and is higher than in most other G7 countries. Such high leverage significantly exposes households and banks to interest-rate, income, and house-price shocks.

41. Further macroprudential tightening may thus be needed if the reduction in high-leverage mortgages does not continue.

  • If needed, such tightening could take the form of tighter LTI and/or LTV limits on new mortgages. Priority should also be given to the consolidation of household-level credit data so as to allow a shift from LTI limits to debt-to-income limits, which cannot be evaded by taking out multiple loans.

  • In addition, the authorities should extend the FPC’s powers of direction to the buy-to-let market, which has accounted for about one-third of gross mortgage growth since 2012 and is dominated by small-scale landlords (owning three properties or less), to avoid biasing the market toward this segment. The powers of direction should mirror those the FPC currently has over the owner-occupied market. Somewhat looser restrictions could be considered for borrowing for new construction to avoid unintentionally restricting supply.

42. Other policies also affect housing demand. The authorities should continue to monitor the Help to Buy program and consider if it needs to be adjusted to avoid adding to demand for existing houses. In addition, continuing to carefully monitor beneficial ownership of legal entities and arrangements holding real estate is crucial for effectively implementing AML/CFT controls.

43. Ongoing efforts to address supply constraints remain essential. Increased housing supply will support near-term growth, reduce the need for excessive household leverage, and promote social cohesion by lessening wealth inequality, as rising house prices have been a key contributor to the latter in the UK. The government has undertaken a number of welcome initiatives to boost housing supply in recent years, such as improving incentives for local governments to approve new construction. The authorities should remain vigilant against local-level resistance to effective implementation of these initiatives—otherwise the risks associated with an approval process perceived by many to be slow and unpredictable will remain. The authorities should continue efforts to mobilize unused publicly-owned lands for construction and explore ways in which property tax reform could ease supply constraints (see fiscal section above).

A01ufig16

UK: Commercial Real Estate Prices<