United Kingdom: Staff Report for the 2016 Article IV Consultation

The UK economy has performed well in recent years, but it faces important challenges and risks. Economic growth has consistently been near the top among major advanced economies, the employment rate has risen to a record high, the fiscal deficit has been reduced, and major financial sector reforms have been adopted. Nonetheless, the economy still faces vulnerabilities, including those related to possible shocks to global growth and asset prices; property markets that have been buoyant in recent years; a wide current account deficit and low household saving rate; and uncertainty about the degree to which productivity growth will recover. In the near term, the largest risks and uncertainties relate to the upcoming EU referendum. Given the importance of the referendum, this report and the accompanying Selected Issues paper include analysis of the referendum's potential macroeconomic implications for the UK and the global economy, while recognizing that this choice is for UK voters to make and that their decisions will reflect both economic and noneconomic factors. This analysis finds that the economic effects of an exit would likely be negative and substantial for the UK. In this event of a vote to leave the EU, policies should be geared toward supporting stability and reducing uncertainty.

Abstract

The UK economy has performed well in recent years, but it faces important challenges and risks. Economic growth has consistently been near the top among major advanced economies, the employment rate has risen to a record high, the fiscal deficit has been reduced, and major financial sector reforms have been adopted. Nonetheless, the economy still faces vulnerabilities, including those related to possible shocks to global growth and asset prices; property markets that have been buoyant in recent years; a wide current account deficit and low household saving rate; and uncertainty about the degree to which productivity growth will recover. In the near term, the largest risks and uncertainties relate to the upcoming EU referendum. Given the importance of the referendum, this report and the accompanying Selected Issues paper include analysis of the referendum's potential macroeconomic implications for the UK and the global economy, while recognizing that this choice is for UK voters to make and that their decisions will reflect both economic and noneconomic factors. This analysis finds that the economic effects of an exit would likely be negative and substantial for the UK. In this event of a vote to leave the EU, policies should be geared toward supporting stability and reducing uncertainty.

Focus of the Consultation

1. The UK economy has performed well in recent years, but it faces important challenges and risks.

  • Economic growth has consistently been near the top among major advanced economies, while the employment rate has risen to a record high.

  • At the same time, economic policies have been broadly in line with past Fund advice: gradual fiscal consolidation has cut the deficit by more than half; monetary policy has remained accommodative, helping to support growth and offset headwinds from fiscal consolidation; financial sector policies have required banks to increase buffers in their balance sheets; and structural reforms have aimed to boost potential output, for example through efforts to ease regulatory impediments to housing construction.1

  • Nonetheless, the economy still faces important challenges and risks: productivity growth is still well below pre-crisis rates; the current account deficit widened to a record high in 2015, driven in part by a further decline in the already-low household saving rate; and loan-to-income ratios on new mortgages are again rising.

  • Perhaps most importantly, UK voters face a momentous choice on June 23, 2016, when a referendum will be held on whether the UK should remain in the EU—a choice that is expected to have important economic implications for the UK, the rest of Europe, and the global economy.

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

  • How have macroeconomic conditions evolved recently?

  • What is the outlook for the economy? What are the main risks?

  • How can the UK’s economic policies support growth and limit risks, both for the UK and globally?

Macroeconomic Context

The economy continued to grow steadily in 2015, with the output gap almost closed. However, near-term uncertainty has risen substantially due to various factors—most notably the forthcoming referendum—and appears to have slowed growth somewhat this year. Under staff’s baseline scenario, which assumes that the UK remains in the EU, growth is projected to recover later this year as referendum-related effects fade. Growth is then expected to average near its estimated potential rate of about 2.2 percent over the medium term. Inflation is projected to rise gradually back to the 2 percent target as effects from past commodity price falls dissipate and as wages rise in response to tighter labor markets. However, this relatively benign baseline scenario is subject to major risks, including those related to the referendum, productivity growth, the buoyant housing market and household debt, and the large current account deficit.

A. Macroeconomic Developments and Outlook

3. The UK economy continued to expand steadily in 2015. Output grew by 2.3 percent, the third straight year of growth in the 2–3 percent range. Growth has been driven by strong private domestic demand, which has more than offset headwinds from gradual fiscal consolidation and persistently weak external demand (Tables 12; Figure 1).

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 Notice 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, 2012–20

(Percentage change, unless otherwise indicated)

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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.

In percent of total household available resources.

Figure 1.
Figure 1.

United Kingdom: Recent Macroeconomic Developments

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.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.

4. Key indicators point to an ongoing post-crisis normalization of macroeconomic and macrofinancial conditions.

  • Standard models suggest that the output gap is now nearly closed, as capacity utilization and the unemployment rate have returned to pre-crisis levels (Figure 2) while the employment rate has reached a record high.

  • Credit conditions continue to turn more expansionary, with net lending by monetary financial institutions (MFI) to nonfinancial corporates turning positive for the first time since the crisis—helping to support higher business investment in 2015—and with mortgage rates falling to new lows (Figure 3).

Figure 2.
Figure 2.

United Kingdom: Indicators of Spare Capacity

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Sources: European Commission; Haver; ONS; and IMF staff calculations.1/ IMF staff estimate.2/ 3-month centered moving average.3/ European Commission.
Figure 3.
Figure 3.

United Kingdom: Housing Market Developments

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Sources: Haver; and IMF staff calculations.
A01ufig1

UK: Employment Rate

(Percent, SA)

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Source: Haver.
A01ufig2

UK: MFI Net Lending to Nonfinancial Businesses

(Y-o-y percent change)

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Source: Bank of England

5. However, several factors heightened uncertainty in the first half of 2016. Foremost among these is the referendum on EU membership. Volatility in global financial markets in early 2016 and downgrades to the global growth outlook alongside increasing concerns about global risks, such as secular stagnation in advanced economies, have further heightened uncertainty.

A01ufig3

UK: News-Based Economic Policy Uncertainty Index

(Mean=100)

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Sources: Economic Uncertainty Index; and Haver.

6. Amidst this uncertainty, annual growth is expected to be slower in 2016. Heightened uncertainty appears to be weighing on confidence and investment, with growth slowing to 1.6 percent (saar) in Q1 and PMI surveys suggesting a further slowdown in April. Under staff’s baseline, which is based on a scenario in which the UK remains in the EU, growth is projected to rebound somewhat in the second half of 2016 as lingering referendum-related effects dissipate, with growth reaching 1.9 percent for the full-year 2016.

7. Growth is then projected to average around 2.2 percent—approximately staff’s estimate of the UK’s potential growth rate—over the medium term (Table 2). However, medium-term growth prospects are heavily dependent on the degree to which labor productivity growth recovers.

  • Labor productivity growth has been very weak in the UK during the recovery, recently running around 0.8 percent (Table 2). Part of the post-crisis decline in productivity growth likely reflects temporary cyclical factors, such as the post-crisis impairment of credit markets inhibiting the flow of investment to more productive sectors (see 2015 Selected Issues). As the economy nears full employment, employment growth should also ease, helping to raise productivity as tighter labor markets spur more efficient labor utilization and as employment growth is driven more by labor force growth and less by the hiring of the unemployed, who tend to have below-average productivity. However, part of the decline in productivity growth also likely reflects more permanent structural factors, given a broad-based productivity slowdown across most advanced economies that is not fully understood and may reflect factors such as changes in the nature of technological progress and/or increased difficulties in measuring it.

  • As cyclical effects wane, staff projects productivity growth to rise over the medium term to around 1.6 percent but to remain well below its pre-crisis historical average of 2.2 percent (1960–2007). However, such projections are uncertain, and moderate deviations could result in substantial differences in output levels over the long run.

8. From a demand-side perspective, a number of offsetting forces are expected to have a roughly neutral effect on growth over the next few years. Growth in the baseline is expected to be supported by a reduction in uncertainty following a Remain vote, by the recent run-up in residential and commercial real estate prices (encouraging investment in these sectors), and by gradually rising global growth (supporting net exports), with ongoing monetary policy accommodation and supportive financial conditions helping to offset broadly unchanged headwinds from steady fiscal consolidation (Table 3).

Table 3.

United Kingdom: Public Sector Operations, 2010/11–20/21 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.

9. Inflationary pressures remain subdued.

  • As of April 2016, headline inflation remained low at 0.3 percent; core inflation was also subdued at 1.2 percent.

  • Low headline inflation partly reflects the large drop in commodity import prices since mid-2014. However, domestic drivers of inflation have also been muted, with nominal private-sector wages growing by only 2.3 percent as of March 2016 (Figure 1). Even if productivity growth remains in the range of only 0.8 percent, this pace of wage growth would still be consistent with underlying inflation of only around 1.5 percent.

  • Consequently, markets do not expect the BoE to raise its policy rate (currently 0.5 percent) for several years. Under this scenario, staff expects inflation to rise gradually to 2 percent by early 2018, as effects from past commodity price declines dissipate and assuming a gradual rise in wage growth in response to tighter labor markets. A planned gradual increase in the minimum wage of 34 percent during 2015–20 will also contribute to higher wage and price inflation.

B. External Assessment

10. The current account deficit has risen substantially in recent years, reaching 5.2 percent of GDP in 2015 (Table 6)—the widest deficit among advanced economies. 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. However, part of the decline in the income balance may also be temporary, reflecting factors such as unusually low returns on British investments abroad (see 2015 Selected Issues and Annex 1).2

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, 2012–20

(Percent of GDP)

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Sources: Office for National Statistics; and IMF staff estimates.
A01ufig4

Current Account Balance, 2015

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Source: International Monetary Fund, World Economic Outlook.

11. The current account was wider than justified by fundamentals in 2015, and sterling appeared overvalued (Annex 1).

  • The EBA current account regression model yields a cyclically adjusted current account balance of -4.8 percent of GDP in 2015 and a current account norm of -0.6 percent of GDP, implying a current account gap of -4.2 percent of GDP and sterling overvaluation of 18 percent. However, the post-crisis deterioration in the income balance is not expected to be entirely permanent, suggesting a somewhat smaller underlying current account deficit and smaller current account gap than implied by the EBA current account model. Taking into account this effect, as well as the somewhat smaller gaps implied by the EBA REER models—both of which estimate overvaluation of 12 percent—and adding uncertainty around these estimates yields an estimated current account gap of -1.5 to -4.5 percent of GDP and REER overvaluation of 5–20 percent in 2015.

  • However, as of April 2016, the REER had depreciated by 7 percent relative to its average 2015 level, possibly unwinding a portion of the estimated overvaluation in 2015.

  • Part of the estimated current account gap (1.1 percentage points) reflects the fiscal balance currently being looser than its optimal medium-term level. Part of the gap also reflects a relatively low household saving rate, which fell to 4.3 percent in 2015 (Table 2).

  • It is important to note that this external assessment and the estimated degree of overvaluation in 2015 are conditional on the baseline scenario in which the UK remains in the EU. An alternative scenario entailing higher trade barriers could reduce the equilibrium exchange rate (as a more competitive exchange rate would be required to raise demand for UK exports to offset the reduced demand from the EU due to higher barriers), implying that additional depreciation from 2015 levels—beyond that implied by staff’s assessment of overvalution in 2015—would be required to restore equilibrium in such a scenario.

UK: Estimated Exchange Rate Overvaluation under Different EBA Approaches

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Source: IMF staff calculation.

12. Some factors mitigate risks associated with the current account deficit. In particular, the BoE’s well-established inflation-targeting framework should help keep inflation expectations anchored in the event that an unwinding of the current account deficit leads to exchange rate depreciation, absent a major regime shift such as an exit from the EU, which would pose a higher risk of de-stabilizing inflation expectations. In addition, the currency composition of the net international investment position (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. A variety of valuation effects have also kept the NIIP at a relatively neutral level (-3.5 percent of GDP at end-2015; Table 7) despite persistent large current account deficits in recent years, and the authorities estimate that the NIIP would be higher if FDI were fully valued at market prices.

Table 7.

United Kingdom: Net International Investment Position, 2010–15 1/

(Percent of GDP)

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Source: Office for National Statistics.

Data correspond to the end of the indicated period, expressed as a percent of the cumulated GDP of the four preceding quarters.

13. Nonetheless, the high and persistent current account deficit is a source of concern. The deficit’s sheer size and its general usefulness as an indicator of underlying imbalances and heightened risks suggests some cause for caution. Although the UK has not had difficulties in financing its deficits so far, events could change market sentiment, triggering abrupt capital outflows. Rapid outflows could in turn adversely affect domestic investment and hence growth, with negative outward spillovers via cross-border linkages. A persistent, high current account deficit is thus best avoided, and policies that assist orderly and gradual external adjustment would be helpful.

C. Risks and Spillovers

14. The relatively benign baseline scenario is subject to a number of important risks. Specific risks are elaborated upon in the Risk Assessment Matrix (Annex 2), including risks related to the current account deficit discussed above in the context of the external assessment. Other risks include the following:

Globally originating risks

  • Global downturn: The outlook for global growth is uncertain, including because global demand may prove too weak to support solid growth, as discussed in the April 2016 WEO, and global markets remain subject to sudden movements, as seen in early 2016. A downturn in global growth would depress exports; tighter global financial conditions (i.e., higher risk premia and lower asset prices) would further depress GDP growth by weighing also on domestic consumption and investment.

  • Persistently low energy prices: Energy prices could remain persistently low if global supply-demand imbalances last longer than expected. Persistently low energy prices would likely have modest positive net effects on growth, with the boost to consumption from higher household disposable income slightly offsetting negative effects on investment in the energy sector. Headline inflation would remain lower for longer. If this results in second-round deflationary effects, this may require more accommodative monetary policy to ensure that inflation expectations remain anchored near the target.

UK-specific risks

  • Medium-term productivity growth. As noted above, productivity growth remains well below its pre-crisis rates, and the degree to which it will recover over the medium term is uncertain. A lack of recovery would have a major adverse effect on long-run output and would also put upward pressure on inflation, while a return to pre-crisis rates would result in substantially higher output than projected in staff’s baseline.

  • Real estate market-related risks. House-price growth has risen to more than three times income growth, and loan-to-income ratios on new mortgages are again rising. A continuation of these trends would increase households and banks’ vulnerabilities to house-price, income, and interest-rate shocks (see later section for further details on recent real estate market developments and related macroprudential policies).

15. However, the largest near-term risk relates to the referendum on EU membership. A vote to leave the EU would create uncertainty about the nature of the UK’s long-term economic relationship with the EU and the rest of the world. It would also have the potential to crystallize some of the baseline risks noted above. Given the importance of the referendum, staff analyzes some of the possible economic effects of a decision to leave the EU in its accompanying Selected Issues paper, while recognizing that the choice of whether to remain in the EU is for UK voters to make and that their decisions will reflect both economic and noneconomic factors. Key points from staff’s analysis are summarized below.

Possible economic effects of an exit from the EU

16. A vote for exit would be followed by a long process with uncertain outcomes.

  • Following a decision to exit, the UK would need to negotiate the terms of its withdrawal and a new relationship with the EU—unless it abandoned single market access and relied on WTO rules, which would significantly raise trade barriers. The process governing exit from the EU is untested, and ratification of a new deal could require unanimous support depending on the nature of the agreement, making it subject to considerable political risks.3

  • As EU-level agreements also cover the UK’s trading relationship with 60 non-EU economies (and prospective arrangements with another 67 countries are in the works), the UK would also need to simultaneously renegotiate these arrangements, or else see them revert to WTO rules.

  • These processes could last many years, given the wide range of issues and countries involved and given that relatively simple bilateral trade agreements have typically taken 3 or more years to negotiate.

  • The UK could unilaterally determine the date of its exit, but a decision to exit would most likely be irrevocable. Once triggered, Article 50 of the EU Treaty provides for a two-year process for negotiating the terms of the departing state’s withdrawal and its future relations with the EU, but there is no requirement for remaining EU countries to reach agreement with an exiting party. An extension to negotiations could be granted, but would require unanimous consent from other EU governments.

17. A protracted period of uncertainty could weigh on confidence and investment and increase financial market volatility.

  • Uncertainty about the outcome of new trade, migration, and regulatory arrangements could discourage investment over the medium term and weigh on consumer sentiment. A change in the UK’s EU membership status could also cause abrupt disruptions to trade and financial flows if new arrangements are not adopted in a timely and smooth manner.

  • Another risk is that markets may anticipate significant negative economic effects from an exit and bring them forward via an adverse market reaction in the immediate aftermath of an exit vote. Such a risk scenario could involve some combination of higher borrowing costs for households and individuals due to higher risk premia, downward pressure on equity and house prices, and even a sudden stop of investment inflows into key sectors such as commercial real estate and finance. The UK’s record-high current account deficit and attendant reliance on external financing exacerbates these risks. Such market reactions would adversely affect economic activity, further dampening asset prices in a self-reinforcing cycle that would be only partly offset by expenditure-switching toward net exports in response to abrupt exchange rate depreciation, which could cause inflation to rise above target for some time. Contagion effects could result in spillovers to regional and global markets, though the main effects would be felt domestically.

  • Indeed, such concerns may have already begun to affect UK markets in recent months. For example, in the commercial real estate market, transactions plunged about 40 percent in the first quarter of 2016. Although the residential real estate market remains buoyant, this may reflect temporary effects due to tax changes, as discussed in more detail later in this report. In financial markets, the UK’s nominal effective exchange rate depreciated 9 percent between November 2015 and April 2016, UK sovereign CDS spreads have risen more sharply than the G7 average, and the cost of hedging exchange rate volatility around the time of the referendum has spiked.

A01ufig5

UK: CDS Spreads Have Risen as Uncertainty Increases

(5-year senior CDS)

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Source: Bloomberg.1/ Excludes Canada due to absence of a functioning CDS market; excludes UK.
A01ufig6

UK: Risk Reversals Show Increased Appetite for Hedging against Sterling Weakness 1/

(GBPUSD 25 delta 3M risk reversal)

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Source: Bloomberg.1/ Risk reversals measure the skew in the demand for out-of-the-money options at high strikes compared to low strikes. It is defined as the implied volatility for call options minus the implied volatility for put options on the base currency with the same delta.
  • That said, uncertainty around the market reaction to a Leave vote is wide, as the historical experience with similar events is limited. At the same time, the reaction is expected to be negative and could be severe.

18. The potential steady-state arrangements following an exit fall within a wide range of outcomes.

  • One end of the spectrum would entail being outside the EU but remaining in the European Economic Area, as is currently the case for Iceland, Liechtenstein, and Norway. However, such an arrangement would grant the UK little change in sovereignty, as the UK would still have to maintain EU regulations governing the free movement of persons, goods, services, and capital, but with greatly reduced influence in determining these regulations.

  • The other end of the spectrum would entail reverting to WTO rules for trade. However, this would significantly curtail access to the EU’s single market and create other non-tariff barriers not covered by WTO rules (such as from no longer being part of the customs union).

  • Between these two extremes is a range of possible outcomes. In general, there would be a trade-off between the UK’s access to EU markets and the degree to which it could unilaterally set regulatory conditions.

19. The steady-state economic effects of an exit would occur via several channels, including the following:

  • Reduced trade and financial flows. An exit is likely to increase barriers to trade and financial flows between the UK and EU, curtailing the benefits from such cooperation and integration, such as those resulting from economies of scale, efficient specialization, and trade-related productivity gains. Such restrictions may also reduce the attractiveness of the UK as an investment destination, including by possibly triggering some activities to relocate elsewhere in the EU. For example, UK financial firms may lose their “passport” to provide financial services to the single market, and much euro-denominated business may eventually move to the continent.4 Such effects could over time erode London’s status as Europe’s preeminent financial center. (See Appendix II of the accompanying Financial System Stability Assessment (FSSA) and the Selected Issues paper for further discussion of the potential effects of a vote to leave the EU on the UK’s financial system.)

  • Regulatory changes. Some exit proponents argue that the UK would be able to adopt a more pro-growth regulatory policy once free of EU restrictions. However, as noted above, maintaining substantial access to the EU’s single market may still require alignment of many UK regulations with those of the EU. Moreover, many EU regulations simply implement global agreements and practices (e.g., Basel III financial-sector regulations and global environmental agreements) that would most likely be maintained even after an exit. The UK also already has relatively flexible labor and product market regulations, so the scope for making these regulations more flexible and pro-growth is somewhat limited. Indeed, some of the UK’s most growth-constraining regulations, such as those on housing construction, are already under domestic control. The fact that regulations heavily affected by EU rules are less restrictive than key regulations under domestic control (e.g., restrictions on housing construction) highlights that regulations could actually become more restrictive and less pro-growth after an exit, as domestic special interests may be able to more easily capture regulatory decision-making following an exit.

  • Fiscal effects. The UK would save its net contributions to the EU budget (around ⅓ percent of UK GDP) if it left the EU. It is unlikely that the UK would save more than this, as the UK budget would likely need to cover some activities currently financed by the EU, such as agricultural support, regional development, and R&D. Moreover, these savings would likely be more than offset by fiscal losses from output declines resulting from reduced trade and investment. Specifically, if steady-state output falls by just 1 percent or more (most estimates are above this—see below), the associated revenue loss would exceed the fiscal savings from not contributing to the EU budget.

20. On balance, the net economic costs of an exit are likely negative and substantial, though there is significant uncertainty about their precise magnitude.

  • Quantifying the effects of an exit with much certainty is difficult, including because the outcome will depend in part on the post-exit arrangements, which are unknown. Qualitatively, however, the considerations discussed above suggest that an exit is very likely to adversely affect the UK economy.

  • In line with this assessment, the vast majority of quantitative estimates by various analysts point to sizeable long-run losses, as increased barriers reduce trade, investment, and productivity. The wide range of estimated losses does not represent fundamental disagreement among most experts that exit would be costly, but largely reflects differing assumptions about the UK’s future economic relationships with the EU and the rest of the world.

  • Several studies examine the likely short- and medium-term effects and find that they would also likely be negative. These include illustrative scenarios by IMF staff in the accompanying Selected Issues paper in which the level of output is 1½ percent below the baseline at its peak deviation in 2019 in a scenario of limited uncertainty effects and 5½ percent below the baseline in a more adverse scenario.

A01ufig7

Comparison of Long-Run Effects on GDP

(Deviation from baseline, percent of GDP)

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Sources: See accompanying Selected Issues paper for references.Notes: bars denote ranges. Diamonds denote midpoints or point estimates.
A01ufig8

Comparison of Short-Run Effects on GDP

(Deviation from baseline, percent of GDP)

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Sources: See accompanying Selected Issues paper for paper references.Notes: All values for 2018, except HMG scenarios, which are for fiscal year 2017/18.

21. An exit would also have important spillovers. Though the UK would be most affected by an exit, other EU economies would similarly experience reduced gains from trade, less efficient matching of capital and labor, and heightened uncertainty during the transition, to varying degrees depending on existing linkages with the UK. Losses from reduced trade and economic integration may rise further if a UK exit increases support for higher barriers elsewhere in Europe. Any effects on the UK financial sector and financial markets may also have outward spillovers to Europe and beyond, given the importance of London as a global financial center. For further discussion of spillovers and other issues related to the referendum, see the accompanying Selected Issues paper.

22. On the other hand, a Remain vote could strengthen the outlook. As noted above, staff’s baseline scenario assumes that referendum-related uncertainty effects dissipate and that effects on financial markets in the run-up to the referendum reverse following a Remain vote, helping to support a rebound in growth in late 2016. Over time, effects could be stronger than assumed in staff’s baseline, posing an upside risk, as enhanced institutional stability could foster stronger growth.

Authorities’ views

23. The authorities broadly shared staff’s baseline outlook and list of key risks. In March 2016, the independent Office for Budget Responsibility (OBR) revised down its 2016 growth projection from 2.5 percent to 2.0 percent, in part due to a softer global outlook. The OBR also revised down medium-term potential and actual growth by about ¼ percentage point due to continued weak productivity growth. The OBR’s projections are now very close to those of IMF staff, the BoE, and consensus forecasts. Staff’s external assessment was viewed as reasonable. On the referendum, the authorities agreed that this posed the largest near-term uncertainty for the outlook. HM Treasury published its estimates of the long-term effects of an exit from the EU in April 2016, while the BoE discussed how EU membership affects the BoE’s ability to achieve monetary and financial stability in a report in October 2015 and discussed possible short-term implications of a vote to leave for monetary policy in its May 2016 Inflation Report.

UK: Growth and Output Gap Projections

(Percent)

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Sources: OBR; IMF staff projections.

Policies to Promote Growth and Stability

Under the baseline of a Remain vote, policies should focus on promoting steady growth while reducing vulnerabilities. In particular, monetary policy should remain on hold until inflationary pressures are clearer and to help offset headwinds from fiscal consolidation. The latter should remain sufficiently gradual to avoid overburdening monetary policy and be supported by further efforts to make the composition of fiscal consolidation more pro-growth and pro-stability. To ensure financial stability, it will be important to complete implementation of the ambitious financial supervisory reform agenda and to have a robust and intrusive approach to supervision and regulation as the financial cycle matures and memories of the crisis fade. Of note, mortgage-related macroprudential policies will need to tighten later this year if the recent re-acceleration of housing and mortgage markets persists. Such a monetary, fiscal, and macroprudential policy mix should help maintain growth while reducing vulnerabilities, including by supporting orderly current account adjustment, and should be reinforced by structural reforms to boost productivity and incomes. Policies will also need to remain flexible and adjust appropriately if circumstances change and risks are realized.

A. Monetary Policy

24. Monetary conditions remain accommodative. Current monetary policy settings—a policy rate of 0.5 percent and QE assets of £375 billion (20 percent of GDP)—have been unchanged since 2012.

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

  • Both headline and core inflation are below target. Forward-looking indicators—such as inflation expectations and wage growth in excess of productivity growth—are also well-contained, with market-based inflation expectations continuing to drift downward in recent months (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 headwinds from ongoing fiscal consolidation.

  • In addition, the very low level of long-term interest rates (the 30-year yield on government bonds was 2.2 percent as of end-May) suggests that the neutral interest rate may be much lower than in the past. Consequently, the current policy rate may not be providing as much monetary stimulus as it may initially appear.

A01ufig9

UK: Sovereign Yield Curve

(Percent)

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Source: Bloomberg.
  • Moreover, risks to policy errors are asymmetric, as the costs associated with 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.

  • 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. If upside risks are realized, monetary tightening may need to be initiated earlier than expected, especially if core inflation or wage growth in excess of productivity growth rises quickly. On the other hand, further easing—which could take the form of policy rate cuts to at least zero, possibly in steps and followed if necessary by additional quantitative easing—is likely to be necessary if demand is weaker than expected and inflation undershooting persists.

Authorities’ views

26. 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. The authorities agreed that in the event of protracted weak demand and price growth there was some scope to further ease monetary policy through cuts to policy rates, further quantitative easing, or a combination of the two.

B. Fiscal Policy

FY15/16 outturn

27. The public sector fiscal deficit fell to about 4 percent of GDP in FY15/16, though the debt ratio continued to rise (Figure 4, Table 3).5 The deficit outturn was broadly in line with projections at the time of the 2015 Autumn Statement. However, the government’s debt target, which requires public sector net debt to fall as a percent of GDP in each year to FY19–20, was not met in FY15/16, in part due to downward revisions to nominal GDP. The deficit remains relatively high by international standards, as to a lesser degree does the debt ratio.

Figure 4.
Figure 4.

Fiscal Developments

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Sources: National authorities; and IMF staff projections.1/ CAPB= Cyclically adjusted primary balance. OBR estimates.
A01ufig10

General Government Deficit and Gross Debt, 2015

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Sources: WEO; and IMF staff projections.

March 2016 budget

28. The March 2016 budget continues to target consolidation, but further smoothes the pace.

  • The March budget avoided undertaking additional tightening in the near term to offset lower revenue projections, following the growth downgrade by the OBR. This lack of an active near-term response implied a modest easing of the pace of structural fiscal adjustment in FY16/17, given that part of the growth downgrade was deemed to be structural.

  • Instead, additional adjustment was backloaded to FY19/20. This allowed the budget to remain consistent with the government’s main fiscal rule, which is to achieve and maintain a budget surplus starting in FY19/20, unless the economy is hit by a significant negative shock, defined as projected real GDP growth of less than 1 percent on a rolling 4 quarter-on-4 quarter basis.

  • Under the new fiscal path, the pace of consolidation is now broadly constant at around 1 percentage point of GDP per year through FY19/20, especially after adjusting for the effects of shifts in the timing of corporation tax payments (blue dotted line in the text chart), which affects the officially measured pace of adjustment but is unlikely to have substantive effects on economic activity. Public sector net debt is projected to start declining as a percent of GDP from FY16/17 onward (Table 3).

A01ufig11

UK: Pace of Fiscal Consolidation

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

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Sources: Office for Budget Responsibility; and IMF staff calculations.1/ The CAPB is adjusted by taking out the effect of the change in corporation tax payment dates for companies with taxable profits over £20 million.

29. Consolidation remains mostly expenditure-based, with new measures in the 2016 budget having only modest fiscal effects. Notable measures include higher taxes on commercial property, tighter restrictions on tax avoidance, lower business taxes, and accelerated infrastructure spending. Admirably, the budget continues to maintain foreign development assistance at 0.7 percent of gross national income in an environment of significant overall spending restraint. However, new measures in the March budget do not address some of the deeper reform needs highlighted in past Article IV reports, such as reforming distortionary tax expenditures.

A01ufig12

UK: Changes in Primary Balance

(Percent of GDP, cumulative from FY2014)

Citation: IMF Staff Country Reports 2016, 168; 10.5089/9781475517231.002.A001

Sources: National Authorities; and IMF staff calculations.

30. The smoothing of the adjustment path and increased backloading of consolidation was appropriate. The lack of additional discretionary tightening in the near term in response to larger deficit projections was appropriate given the weaker near-term outlook, the need to support demand, and the heightened near-term uncertainty. This new pace of structural adjustment, which is essentially unchanged from last year, is appropriate in a baseline in which growth strengthens later this year following a Remain vote, given that the output gap is essentially closed, the employment rate is at a record high, and financial conditions continue to ease in line with stronger bank balance sheets. Moderate fiscal consolidation in such a scenario will help rebuild fiscal buffers to allow a more forceful countercyclical response during the next downturn. More generally, the pace of consolidation should be broadly calibrated to cyclical conditions.

31. In this context, the UK has fiscal space to ease further if this becomes necessary. The UK has room to ease in the sense that, in the baseline of a Remain vote, a moderate fiscal easing is unlikely to trigger a significant rise in sovereign bond yields. In the event of an extended period of sluggish demand growth and inflation undershooting, the government should use this fiscal space and the flexibility in its fiscal framework to halt structural adjustment and, if necessary, move to stimulus.6 Automatic stabilizers should also be allowed to operate freely and symmetrically. 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.

Structural fiscal reforms

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

  • Boosting infrastructure. Spending on infrastructure has been increased in recent budgets, but further efforts could be made in this direction, given that needs in this area are still high and given that public investment is still below the average in other advanced economies. Higher infrastructure spending could be funded by reforms such as those below.

A01ufig13