United Kingdom: Staff Report for the 2018 Article IV Consultation
Author: International Monetary Fund. European Dept.
Publication Date:
14 Nov 2018
eISBN:
9781484384589
Language:
English
Keywords:
ISCR; CR; derivatives clearing service; IMF staff calculation; productivity challenge; Brexit negotiations; IMF staff estimate; EU exit; Brexit preparation work; Productivity; Income; Inflation; Global; potential GDP; foreign currency; enforcement effort; cross-government intelligence sharing; EU membership
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October 25, 2018

Abstract

October 25, 2018

October 25, 2018

Key Issues

Context and Outlook. The United Kingdom is set to exit the European Union in March 2019. It is now in the process of negotiating its withdrawal from the EU. Once an agreement is reached, there will be an implementation period through the end of 2020. Complex issues still remain to be resolved, including the future status of the land border with Ireland. Growth over the past year has been moderate. The post-referendum depreciation caused an increase in inflation, depressing private consumption. Business investment growth has been constrained by protracted uncertainty about the future trade regime and potential increases in trading costs. Nonetheless, slack in the economy is limited as weaker demand is matched by slower supply growth. Growth is expected to continue at a moderate pace, conditional on a smooth Brexit transition and some recovery in labor productivity. A key downside risk is an exit without an agreement with the EU, accompanied by disruptive asset price movements.

Policies. While a disorderly Brexit remains the largest risk to the economy, the UK faces a raft of issues that predate the referendum, including relatively large public debt and current account deficit, and low productivity growth. Sustained fiscal consolidation would help restore fiscal buffers and prepare public finances for the expected increase in demographic-related spending. The pace of further tightening of the monetary policy stance should be gradual and data-dependent given high uncertainty about the future macroeconomic environment. Structural reforms to boost productivity and facilitate reallocation of resources post-Brexit would help promote inclusive and sustainable growth. Continued focus on strict prudential supervision is warranted in the context of relatively easy financial conditions and Brexit-related risks. Close collaboration with the EU prudential authorities will be essential to maintain a smooth functioning of the financial system and minimize risks.

Approved By

Philip Gerson (EUR) and Rupa Duttagupta (SPR)

Discussions took place in London during September 3–17, 2018. The staff team comprised P. Gerson (head), D. Iakova, N. Arregui, J. Chen, R. Espinoza (all EUR), and T. Gudmundsson (MCM). J. Pampolina, C. El Khoury (both LEG), L. Gornicka, O. Ftomova and R. Vega (all EUR) supported the mission from headquarters. The Managing Director met with the Chancellor and the Bank of England Governor and held a press conference at the end of the mission.

Contents

  • RECENT DEVELOPMENTS

  • OUTLOOK

  • RISKS AND SPILLOVERS

  • EXTERNAL ASSESSMENT

  • POLICY DISCUSSIONS

  • A. Monetary Policy

  • B. Fiscal Policy

  • C. Financial Sector Policies

  • D. Contingency Planning for a Disorderly No-Deal Brexit

  • E. Structural Reforms

  • F. Corporate Transparency and Anti-Corruption Efforts

  • STAFF APPRAISAL

  • FIGURES

  • 1. Physical and Human Capital

  • 2. Recent Macroeconomic Developments

  • 3. Inflation

  • 4. Labor Market Developments

  • 5. External Sector

  • 6. Fiscal Developments

  • 7. Non-Financial Corporate Health

  • 8. Credit Market Developments

  • 9. Housing Market Developments

  • 10. Inequality

  • 11. Migration

  • TABLES

  • 1. Selected Economic Indicators, 2014–2019

  • 2. Medium-Term Scenario, 2013–23

  • 3. Statement of Public Sector Operations, 2010/11–22/23

  • 4. Balance of Payments, 2013–23

  • 5. Net Investment Position, 2013–23

  • ANNEXES

  • I. External Sector Assessment

  • II. Risk Assessment Matrix

  • III. Debt Sustainability Analysis

  • IV. Implementation of Fund Past Advice

Recent Developments

1. The United Kingdom is set to exit the European Union in March 2019. The two sides have agreed to a 21-month implementation period—during which the UK will remain in the single market and the customs union, and abide by all existing EU rules—but this is contingent on ratifying a withdrawal agreement and agreeing on a framework for the future relationship by March. Difficult and complex issues are still to be resolved, including the nature of the land border with Ireland, and the outline of the trade, legal, and institutional relations after Brexit.

2. Output growth has been moderate in the two years since the referendum. Private consumption has been constrained by slow real income growth (Figure 2). At the same time, business investment remains lower than would be expected in the context of robust global growth and favorable financing conditions. Staff analysis suggests that uncertainty about the future relationship and expectations of higher trade costs after Brexit have contributed to this (Box 1). The softening of domestic demand was partially offset by a higher contribution from net exports in 2017, supported by weaker sterling and strong external demand.

Figure 1.
Figure 1.

United Kingdom: Physical and Human Capital

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources:FAD Investment and Stock Database (2017); OECD Survey of Adult Skills (2015); World Economic Forum; and IMF staff calculations.
Figure 2.
Figure 2.

United Kingdom: Recent Macroeconomic Developments

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Haver; and IMF staff calculations.1/ Non-energy industrial goods, and unprocessed food.2/ Processed food, alcohol, tobacco, and transportation services.3/ Excluding contributions from erratic terms and statistic discrepancies.4/ Excluding inventories.

Growth Performance of G7 Countries

(Y/y growth rates, in percent)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Haver Analytics; and IMF staff estimates.

3. Despite limited slack in the economy, inflation has moderated as the effects from the past sterling depreciation are fading. Potential growth has slowed in the last two years as productivity remains subdued and labor force growth diminished, partly due to a decline in net migration inflows from the EU (Figure 11). As a result, slack in the economy has diminished despite weak demand. The unemployment rate fell to 4 percent in mid-2018 despite a record high labor force participation rate, and wage growth has started to firm (Figures 2 and 3). Headline CPI inflation declined to 2.7 percent in August from 3.0 percent in January, while core inflation fell to 2.1 percent, as import price pressures have diminished.

Figure 3.
Figure 3.

United Kingdom: Inflation

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Haver; Bank of England; IMF WEO database; and IMF staff calculations.1/ Derived from government securities, assuming RPI inflation exceeds CPI inflation by 1 percentage point.2/ Labor cost (per worker) over productivity.
Figure 4.
Figure 4.

United Kingdom: Labor Market Developments

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Haver; ONS; and IMF staff calculations.
Figure 5.
Figure 5.

United Kingdom: External Sector

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Haver; INS; and IMF staff calculations.
Figure 6.
Figure 6.

United Kingdom: Fiscal Developments

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: National authorities; and IMF staff calculations.Note: English housing associations are re-classified from the public to the private sector starting in FY2017. They contribute 0.2 and 3.3 percent of GDP to net borrowing and net debt, respectively.
Figure 7.
Figure 7.

United Kingdom: Non-Financial Corporate Health

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Moody’s KMV, Orbis, and IMF staff calculations.
Figure 8.
Figure 8.

United Kingdom: Credit Market Developments

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Bank of England; BIS; Council of Mortgage Lender; Haver; Bloomberg Finance L.P.; and IMF staff calculations.1/ Calculated by weighting the responses of lenders’ responses.
Figure 9.
Figure 9.

United Kingdom: Housing Market Developments

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Bank of England; BIS; ONS; Haver; and IMF staff calculations.1/ Housing assets for 2016 and 2017 are derivated using house prices.
Figure 10.
Figure 10.

United Kingdom: Inequality

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: OECD; SWIID; Corak (2015); and IMF staff calculations.1/ Measures inequality in disposable income, post taxes and transfers. Based on OECD data. 2016 data for countries with star.2/ Measures inequality in disposable income, post taxes and transfers. Based on the Standardized World Income Inequality Database (SWIID).3/ Intergenerational income elasticity is defined as the percentage difference in the adult earnings of a son/daughter for each one percentage point increase in the parents’ earnings.
Figure 11.
Figure 11.

United Kingdom: Migration

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: ONS: Long-Term International Migration, National Population Projections; OECD; LSE CEP Labor force survey; Migration Observatory analysis of Labour Force Survey; and IMF staff calculations.1/ Weighted average of four quarters 2015 and excludes industries with fewer than 5,000 EU-born workers.2/ Baseline on ONS National Population Projections: 2016-based projections.

4. The macroeconomic policy mix is mildly accommodative. After a moderate fiscal consolidation in 2017, the fiscal stance in 2018 is projected to be broadly neutral, although ex-post revisions to fiscal and GDP data make it difficult to do a precise assessment of the fiscal stance in real time. Continued gradual consolidation is envisaged over the next three years. Monetary conditions are still accommodative, with the policy rate at 0.75 percent, below staff’s estimate of the neutral rate (about 1½ percent).

5. Total credit is growing in line with GDP, although consumer credit continues to expand faster. At 8.1 percent yoy in August, consumer credit growth remains high relative to income growth. Mortgage rates are at record low levels in part due to intense bank competition. Corporate lending rates have inched up—reflecting some widening of bank funding spreads and global factors, such as monetary policy normalization in the US (Figure 8).

Financial Conditions Index

(Standard deviations)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Source: IMF staff calculations.Note: Higher values of the index denote tighter conditions. Computed based on various measures of risk pricing, leverage, and external conditions (see IMF GFSR October 2017 Annex 3.2 for details).

Outlook

6. The outlook is subject to significant risks, primarily reflecting uncertainty about the outcome of the Brexit negotiations. The baseline scenario—which should not be construed as a projection about the most likely outcome of the current negotiations—assumes that Brexit negotiations conclude on schedule, culminating in a free trade agreement for goods, a moderate increase in non-tariff barriers for services, and a smooth transition to the new equilibrium. It also assumes a tighter migration regime over the medium term (see Box 2 for a detailed description of the assumptions). In this central scenario, growth would remain modest around 1½ percent.

  • Export growth should be supported by steady global demand. With UK growth underperforming the rest of the world, imports are expected to remain subdued and net exports should continue to make a small positive contribution to growth.

  • Household consumption is expected to grow at a moderate pace, broadly in line with real disposable income growth. Inflation is projected to decline gradually toward the target over the next year.

  • Business investment should be supported in the near term by export demand and favorable financing conditions. However, uncertainty will continue to constrain investment growth until there is greater clarity on post-Brexit trading arrangements.

  • Labor productivity is projected to recover somewhat. Over the medium term, GDP growth is expected to average around 1½ percent, consistent with a projected modest strengthening of trend labor productivity growth to about 1 percent (still well below pre-crisis levels). Some of the negative factors affecting productivity growth after the crisis, such as bank deleveraging and labor hoarding, have faded, which should support productivity growth. Investment in labor-saving technologies and the efficiency of labor utilization should also increase with the economy at full employment.1

Labor Productivity Growth

(Y/y percent change)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Haver Analytics; and IMF staff calculations.

Risks and Spillovers

7. An exit from the EU without an agreement on the future relations is the most significant risk to the outlook.

  • Leaving the EU without an economic agreement, even in an orderly manner, or reaching an agreement with high barriers to trade in goods and services would lead to lower-than-projected medium-term growth. A scenario in which future trade between the UK and the EU is governed by WTO rules is estimated to bring about output losses of around 5 to 8 percent compared to a no-Brexit scenario in the long run.2

  • A worst-case scenario would be a disorderly exit from the EU without an implementation period. In such a scenario, a sudden shift in investors’ preference for UK assets could lead to a sharp fall in asset prices and a hit to consumer and business confidence, which in turn would have adverse impact on the balance sheets of households, firms and financial intermediaries. Sterling would depreciate further, raising domestic prices and affecting households’ real income and consumption. A disorderly exit is likely to lead to widespread disruptions in production and services. External trade would be affected as the UK would start trading immediately on WTO terms, while the needed customs infrastructure may not be fully in place on both sides of the border, causing significant delays. In addition, without continued mutual recognition of existing product standards, approvals for exports could become much more cumbersome. Services trade would be severely restricted by the loss of market access, including passport rights. While it is difficult to calibrate precisely the likely economic impact of this scenario, the magnitude of the disruptions and the loss of output would be more severe than in an orderly exit on WTO terms with a transition period.

  • On the upside, an agreement featuring fewer impediments to trade than assumed in the baseline could buoy confidence, activity, and asset prices. New trade arrangements with countries outside the EU could offset some of losses on trade with the EU over the long run.

8. Other external or domestic risks could also affect the outlook (Annex II).

  • The projected sustained strengthening of labor productivity growth could fail to materialize. Weaker-than-projected investment growth and a decline in the number of skilled migrants may depress productivity growth.

  • The need to finance the large current account deficit makes the economy vulnerable to shifts in investors’ preferences for UK assets. An abrupt reduction in net capital inflows would lead to tighter domestic financial conditions, raising refinancing risks for leveraged firms and households. Foreign investors have a large presence in some riskier UK assets, such as commercial real estate (CRE) and leveraged loans. Shifts in inflows could be triggered by concerns over UK prospects or by changes in global financial conditions.

  • Still-high valuations of CRE, and to a lesser extent housing, are additional sources of risk to the outlook. CRE is widely used as collateral for corporate borrowing, so a sharp adjustment in CRE prices could limit companies’ access to credit and new investments.

  • Households have reduced their savings since the referendum vote, smoothing consumption as real incomes declined. A faster rebuilding of savings would help improve the external accounts but would also depress consumption growth.

  • External risks. A deceleration of global growth would hurt UK’s economic performance. Moreover, a global retreat from economic integration would affect UK exports and deter investment. A credit downturn in China or stress in the euro area could impact globally-exposed UK banks. While global financial conditions remain very accommodative, market sentiment could change rapidly, raising global risk aversion.

9. A rise in trade barriers between the UK and the EU would imply losses for both sides. The integration of economies within the EU has increased over time. As the UK leaves the block, the remaining countries would be affected by reduced gains from trade, capital and labor mobility. The spillover effects will differ among countries depending on the strength of their linkages with the UK. In a Free Trade agreement (FTA) scenario, the impact would range from nearly zero for the least affected economies to almost 3 percent of GDP for Ireland.

Long-Term Impact of Brexit: FTA scenario

(Decline in the level of output compared to a no-Brexit scenario; In percent)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Source: IMF staff calculations.

Authorities’ Views

10. The authorities shared a similar view on the baseline growth outlook and risks. Conditional on a relatively smooth Brexit process, the Office for Budget Responsibility and the Bank of England project growth to remain modest by historical standards. They noted that spare capacity in the economy is currently limited, and that potential supply growth in the future was likely to be lower relative to past averages, in part as a result of reduced net migration and subdued investment growth. A disorderly no-deal exit from the EU in March 2019 is the main downside risk to the outlook. Beyond Brexit, the authorities shared staff’s view on the key domestic and global risks. The medium-term growth outlook would depend on the outcome of the Brexit negotiations and the recovery of productivity growth.

External Assessment

11. The current account balance has narrowed significantly but the deficit still exceeds its average historical values. The current account deficit shrank to 3.7 percent of GDP in 2017 (Figure 5). The improvement in trade and primary income balances was driven by the post-referendum currency depreciation and a stronger global economy, which boosted UK exports and returns on the UK’s foreign currency-denominated assets. From a savings perspective, the improvement reflects significant increases in savings by the government and private corporations, only partly offset by net dissaving by the household sector. From a financing perspective, the share of debt inflows—which may be more vulnerable to refinancing risks—has increased. The current account deficit is projected to narrow further to about 3 percent over the medium term as import growth decelerates in line with subdued domestic demand.

Current Account Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Haver Analytics; and IMF staff calculations.

Saving – Investment Balance, by Sectors

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Haver Analytics; and IMF staff calculations.

Capital Flows

(Cumulative flows in percent of cumulative GDP)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Haver Analytics; and IMF staff calculations.

12. Risks to the UK’s external position have been partly mitigated by the stabilizing role of persistent positive valuation effects. High current account deficits leave the economy vulnerable to a reduction in foreign investors’ appetite for UK assets. However, the currency composition of the UK’s international investment position (IIP) mitigates to some extent these risks. The UK’s external assets have a higher foreign currency component than do its external liabilities. Therefore, sterling depreciation increases the net IIP balance and improves net income (in the absence of offsetting changes in gross investment flows). Persistent positive valuation effects, reflecting an increase in the value of UK investors’ holdings abroad, have helped stabilize UK’s net IIP over the last 20 years despite large cumulative current account deficits.3

13. The external position remains weaker than justified by fundamentals. The external balance assessment suggests that the current account gap was between 1 and 5 percentage points of GDP in 2017 (Annex I), and preliminary data suggests the assessment will be broadly unchanged for 2018. The depreciation of sterling after the referendum has helped improve net trade and should continue to support exports somewhat going forward. Moreover, some of the post-crisis deterioration of net returns on overseas investment is expected to be reversed as UK growth lags trading partners’ growth. Staff’s assessment is that the real exchange rate overvaluation in 2017 was in the range of 0 to 15 percent, although there is substantial uncertainty around this assessment as the UK’s future trade arrangements remain unknown. Should Brexit lead to a significant increase in trade barriers, the equilibrium exchange rate could be lower. Thus far in 2018 sterling has been broadly unchanged in real terms.

Authorities’ Views

14. The authorities agreed that the large current account deficit creates vulnerability to a reversal of capital flows. However, they noted the recent narrowing of the deficit, and stressed that the strong macroeconomic policy framework and the healthy capital and liquidity positions of UK banks should help maintain investors’ confidence in UK assets. The Bank of England also noted that persistently positive valuation gains have helped stabilize the net IIP position in the past. There is greater uncertainty than usual around assessments of the sustainable current account and the equilibrium exchange rate given the wide range of possible future trade arrangements with the EU.

Policy Discussions

15. Policies should focus on maintaining macroeconomic stability and boosting productivity. The envisioned gradual steady reduction in public sector deficits and debt would help rebuild buffers, maintain investor confidence, and lower the current account deficit. The pace of tightening of monetary policy should be gradual and data-dependent in the context of the high degree of uncertainty about the future macroeconomic environment. Structural policies should continue to focus on raising competitiveness and potential growth over the medium term. Brexit will lead to important shifts in the structure of the UK economy, and policies could facilitate the transition. In doing so, however, measures should seek to support workers and not particular jobs or sectors. In the financial sector, continued prudent oversight would be necessary to ensure resilience to risks and to prevent a relaxation of credit standards. Across the full policy-making spectrum, it is important to have in place contingency plans to maintain economic and financial stability in case of a disorderly exit from the EU.

16. The UK government has taken a number of steps to prepare for the administrative and legislative changes that Brexit will require. Parliament has passed legislation converting into UK law the legislative framework currently encompassed in EU laws. The government has guaranteed EU program funding committed to projects in the UK before the end of 2020 and is working to ensure that the UK maintains access to critical items like medicines. A budgetary allocation of £3 billion has been established to help fund the costs of Brexit preparation, and thousands of civil servants have been hired to help shoulder the workload. The government has begun publishing technical notices setting out information to allow private stakeholders to understand what they would need to do in a no deal scenario, so they can make informed plans and preparations. The government has also committed to providing temporary permissions for EU financial institutions to continue to operate in the UK to provide continuity at the moment of departure from the EU.

17. Nevertheless, the range of remaining issues to prepare for Brexit is large, underscoring the importance of securing an implementation period. The UK will have to bolster human, physical, and IT resources in customs and other services, and establish domestic agencies to operate in place of EU ones. In addition, the government will need to renegotiate the hundreds of bilateral and multilateral international agreements to which it is now party via its EU membership. Many of the required tasks cannot be initiated until there is greater clarity on the future trade relationship with the EU. There are, accordingly, risks of serious disruptions without an implementation period in place. Irrespective of the shape of the new economic relationship post Brexit, continued close cooperation between the UK and the EU authorities in different policy areas would be mutually beneficial.

A. Monetary Policy

18. Monetary policy remains accommodative, despite a cumulative 50 basis point increase in Bank Rate over the last 12 months. The Bank of England raised the policy rate by 25 basis point to 0.75 percent in August, citing limited slack in the economy as unemployment rates fell to historical lows, productivity performance remained lackluster, and net migration flows slowed down. The nominal policy rate is still below the Fund staff’s estimated neutral rate of about 1½ percent.4 The Monetary Policy Committee (MPC) also voted to maintain the stock of gilts and corporate bonds on the Bank’s balance sheet. A Term Funding Scheme for banks was closed at the end of February 2018 (a total of £127 billion was drawn and banks must repay the funds within four years).

Monetary Instruments

(Percent, left; percent of GDP, right)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Haver Analytics; and IMF staff calculations.1/ Based on Krippner (2011–2015).

19. While import price pressures are easing, domestic labor costs are on the rise. Import price inflation has declined in recent months as the impact of past sterling depreciation on prices is fading. At the same time, the unemployment rate is historically low despite a record high labor force participation rate. Private sector pay growth has strengthened in the context of a tight labor market, while productivity growth remains modest. Unit labor costs increased by about 2½ percent yoy in the first half of 2018 and are projected to remain relatively high in the near term, which would push up domestic cost pressures further. High energy prices are expected to keep headline inflation above 2 percent for the rest of 2018, with a gradual convergence to target projected next year.

Monetary Policy Stance 1/

(Percent)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Source: IMF staff calculations.1/ Real rates are calculated using market based inflation expectations.2/ Based on Pescatori and Turunen (2015).

Import Price Inflation

(yoy percent change)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Haver.

Estimated Nominal Wage Growth

(yoy percent change)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: ONS and IMF staff calculations.

20. A modest further tightening of monetary policy over the next two years would likely be needed to ensure that inflation converges sustainably to the target. Domestic inflation is expected to continue to firm as labor supply remains constrained by falling migration and wage growth exceeds productivity growth. If excess demand pressures persist after domestic inflation has reached a level consistent with the 2-percent target, further gradual tightening of monetary policy would be needed to help keep inflation close to the target and inflation expectations anchored. However, policymakers should stand ready to respond flexibly to data developments in an environment of greater-than-usual uncertainty about the outlook. If negative surprises related to the Brexit negotiations depress domestic demand (relative to supply) further, accommodative conditions should be maintained for longer. Transparent and timely communication will remain important to guide market expectations.

21. The Bank of England’s strategy for reducing its balance sheet in the future is appropriate. The Bank intends to continue to use Bank Rate as the main policy instrument. The MPC announced that it does not intend to start reducing the stock of purchased assets until Bank Rate reaches around 1.5 percent, a level from which it could be cut materially if needed to react to shocks.5 Staff agreed with this strategy. There was also an agreement that when it becomes appropriate, the Bank should start reducing its balance sheet in a gradual and predictable manner. In a recently published paper, the Bank confirmed that it expects to continue to use a floor system to control short-term interest rates, meeting fully banks’ demand for reserves at the Bank Rate. This system implies that in the long run the size of the central bank balance sheet will depend on the demand for reserves and would likely be higher than pre-crisis due in part to changes in liquidity regulations. Staff and authorities agreed that asset sales may have to be coordinated with the UK debt management office to minimize the impact on market liquidity conditions. The Bank will need to monitor short term money markets to determine the equilibrium value of the balance sheet. A clear communication of the Bank’s approach to asset sales and the indicators that it will use to determine the end-point for normalization would help guide the market.

22. The new Bank of England capital framework should reinforce the Bank’s independence and policy credibility. The new arrangements establish a rules-based framework to define the Bank’s capital needs and its income distribution policy. The framework provides adequate financial resources to ensure the Bank’s independence and back its monetary policy and financial stability mandates.

Authorities’ Views

23. The authorities reiterated that future increases in the Bank Rate are likely to be gradual and limited. The authorities expect that domestic cost pressures will keep rising as labor market pressures feed into higher wages. They noted that there were signs of rising wage pressures, such as strong pay growth for recently hired workers. They also noted that the effect of Brexit on monetary policy is difficult to predict since exit could be accompanied by significant supply shocks whose impact could dominate those of lower demand. They agreed that the balance sheet should be reduced in a predictable and well-communicated manner.

B. Fiscal Policy

24. Steady fiscal consolidation remains critical to rebuild buffers against future shocks. Fiscal consolidation over the last decade has substantially reduced deficits. In 2017, the headline deficit declined below 2 percent of GDP and the cyclically-adjusted primary deficit was virtually eliminated (Figure 6). However, at 85 percent of GDP general government debt remains relatively high from a cross-country perspective. Bringing the debt ratio down is important to create buffers that will allow the public finances to weather future shocks. The authorities’ fiscal stress tests and staff’s debt sustainability analysis (Annex III) show that the fiscal position is highly sensitive to negative macroeconomic shocks. The FY2018 budget envisages narrowing of the cyclically-adjusted public sector deficit to ¾ percent of GDP by 2022. This pace of adjustment would set debt on a downward path (Box 3) and also help reduce the current account deficit.

Public Sector Net Balance

(4q-rolling; in percent of GDP)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources:Haver Analytics, OBR, ONS, and IMF staff calculations.

25. However, spending pressures pose risks to the current fiscal plans. In June 2018, the government pledged an increase in the funding for the National Health Service over five years, corresponding to an average real health spending increase of 3.4 percent per year starting next year (about 1 percent of GDP total increase by FY2023). Such a permanent increase in spending should be matched by a corresponding increase in funding, financed either from new revenue sources and/or offsetting spending cuts elsewhere in the budget. If the additional spending is left unfunded, gross government debt would remain around current levels over the forecast horizon instead of declining.6 In addition, the margin against the 2 percent of GDP cyclically-adjusted overall balance target for FY2020 would be significantly reduced, limiting the room for policy responses to shocks.

Source: IMF staff projections based on Autumn Budget 2017 and Spring Update 2018.Note: NHS pledge nominal values from OBR FSR 2018. Debt ratios are shown for general government instead of public sector to abstract from BoE’s operations.

26. Adverse growth effects related to Brexit create further challenges. Each 1 percentage point reduction in nominal GDP reduces fiscal balances by about 0.4 percentage points. Most analysts estimate output costs relative to a no Brexit scenario to be well above 1 percent of GDP.7 Staff projections in Box 2 suggest that even under the baseline scenario of a broad FTA, medium-term output in the UK would be between 2½ and 4 percent lower than under a “no Brexit” counterfactual. If Brexit disproportionately affects relatively tax-rich sectors like finance, the revenue impact could be even larger. Reduced migration will also have a negative budgetary impact, as EU migrants tend to be younger and more skilled than the UK average, making them net contributors to the fiscal accounts. These negative budget effects exceed any savings from lower net EU contributions and exacerbate the longer-term budget pressures that pre-date Brexit.

27. As in many advanced economies, population aging is likely to put considerable pressure on the budget over the longer term. Spending on health (driven by rising cost pressures) and pension benefits is projected to increase by four percentage points of GDP between 2023 and 2043. In the past, increased spending on health and pensions has been largely offset by a reduction in expenditures in other areas, such as in defense and interest payments. However, going forward, interest payments will increase in line with monetary policy normalization. Moreover, identifying efficiency gains to reduce spending in other areas, without reducing the quality or quantity of public services, may be harder following several years of consolidation. Absent a fundamental rethinking of the size and role of the public sector, revenue measures will likely need to play a more prominent role in the next phase of the fiscal consolidation.

28. Tax reforms can reduce economic distortions and create room for growth-enhancing infrastructure spending.

  • Scaling back distortionary tax expenditures (such as removing preferential VAT rates) would improve tax neutrality and reduce pressures to cut more productive public spending.8 Transparency would be enhanced by regular assessments of whether the tax expenditure schemes can be justified compared to other policy instruments.9

  • Reducing the tax code’s bias toward debt, for example by adopting a tax allowance for corporate equity, could help promote financial stability.

  • Property tax reform would reduce vulnerabilities in the housing market by easing supply constraints. Rebalancing property taxation away from transactions and toward property values could boost labor mobility and encourage a more efficient use of the housing stock. Reducing council tax discounts for single-occupant properties could also increase utilization.

  • Moving towards a more equal tax treatment of employees, the self-employed, and corporations would reduce incentives to switch to a different legal form of work for tax reasons and bring the tax system in line with evolving employment practices.10

EU: VAT, Compliance, and Policy Gaps 2015

(Percent of potential revenue)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Source: IMF Fiscal Monitor (2018).Note: Policy gap = difference between potential VAT revenue if all final consumption were taxed at the current standard rate and potential VAT given the current policy framework. Compliance gap = difference between potential VAT revenue that could have been collected given the current policy framework and actual accrued VAT revenue. VAT = value-added tax.

29. Policy alternatives should be explored to address health and pension spending pressures.11 The strain on public finances related to the aging of the population will require making difficult social choices going forward. Either taxes and fees will have to increase, or health services and pension payments will be affected.

  • Health. Cross-country analysis indicates that the UK may have some room for further efficiency gains. On the revenue side, the share of out-of-pocket payments is lower in the UK than the mean for other advanced countries. Accordingly, higher taxes or higher cost-sharing through user fees could also be considered, although the latter would be controversial.

  • Pensions. Further increases in the state pension age (beyond those already legislated) may be needed as life expectancy continues to increase, although it should not be the sole means of adjustment, as it may disproportionately affect groups with lower-than-average life expectancy. The triple lock guarantee on state pensions—which guarantees an annual increase in the state basic pension payment equal to the highest of 2½ percent, CPI inflation, or the rise in average earnings—is an unsustainable method of indexation, poorly targeted to those most in need, and not in line with international best practices (which generally maintain a constant real income in retirement via indexation to CPI). Means testing of access to social benefits in old age could also help control pension spending, while safeguarding the most vulnerable and mitigating income inequality.12

Authorities’ Views

30. The authorities underscored their commitment to meet the fiscal rules and reduce public debt. They agreed that bringing the debt ratio down is important to maintain credibility of the fiscal framework and to regain room to support the economy if a negative shock hits, as noted in their recent Managing Fiscal Risks report. On the funding of the increased health spending, the authorities cited the Prime Minister’s remarks on the need for taxpayers to contribute in a fair and balanced way. Authorities are mindful of the long-term fiscal challenges posed by an aging population and have taken action to improve the sustainability of the pensions system. For instance, the currently legislated increase in state pensionable age to 68 will be brought forward from 2046 to 2039. The authorities highlighted that their strategy to boost productivity growth will help maintain fiscal sustainability.

United Kingdom: Health and Pension Spending Pressures Background

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Eurostat, Haver Analytics; OBR FSR 2017; OECD; ONS; WDI database; WHO database; and IMF staff calculations.Note: LE= Life expectancy; HALE = Health-adjusted life expectancy. Potential gain in LE/HALE is computed using Data Envelope Analysis (DEA). Private health spending includes voluntary schenes and out of pocket expenditures on health. Double-lock premium estimated as the average difference between the maximum of earnings growth and CPI inflation, and earnings indexation, over the period 1990–2016. Triple and double lock premia are computed for illustrative purposes and do not denote the formal method of pension indexation in different countries.

C. Financial Sector Policies

Brexit Implications for the Financial System

31. The UK financial industry will be significantly affected by Brexit. Banking activities, including mortgages, cross-border banking, and deposit taking, will be most affected by the loss of passport rights. The asset management industry may see a smaller impact as its activities could benefit from existing third-country frameworks, although approvals will have to be granted (GFSR, October 2018). Typically, free trade agreements do not cover services. Staff’s assumption in the baseline is that non-tariff costs for services will rise to half of the estimated non-tariff trade costs that have been eliminated due to UK’s EU membership. Under this assumption, value added in the UK financial sector would fall by about 15 percent, with some increase in activity likely in the EU and US. In case of a no-deal Brexit, the output losses could be even greater.13 Nonetheless, London would remain a large financial center as the majority of non-EU facing business is likely to stay in the UK.

32. The authorities are working with financial institutions to prepare for Brexit. There has been significant progress in converting relevant EU financial sector legislation into UK law, including the preparation of secondary legislation where needed and the replication of EU institutional capacity. The UK government has committed to bringing forward legislation to create temporary permission regimes to allow EEA financial services firms and funds to continue their activities in the UK for a time-limited period after the UK has left the EU, providing a backstop in case a Brexit agreement is not ratified. EU policymakers have also issued advice to financial institutions to step up preparations for a “cliff-edge” Brexit. Risks to financial stability include both direct effects from potential disruptions to the provision of financial services (see October 2018 GFSR) and indirect effects from macroeconomic shocks. The BoE’s 2017 annual cyclical stress test suggests that the major UK banks are sufficiently well-capitalized to withstand a range of macroeconomic shocks that could be associated with Brexit (even if compounded by a global recession).14

33. Regulatory and supervisory cooperation between UK and EU authorities will be crucial to maintaining the integrity of cross-border transactions and business. A technical working group, chaired by the heads of the BoE and the ECB, has been established to discuss Brexit-related financial stability risks in the period around 30 March 2019. As suggested in the 2018 EU Financial Stability Assessment, the EU and UK authorities should work together to ensure legal continuity in insurance and derivative contracts and proper data sharing to avoid cliff-edge effects. The potential loss of euro-denominated derivatives clearing permissions for EU banks on UK-based CCPs could generate short-term financial stability risks related to the continuity of existing contracts, as well as netting efficiency losses related to the fragmentation of derivatives clearing. Changes in the regulation and oversight arrangements for euro-denominated derivatives clearing on UK-based central counterparties (CCPs) will require careful design to ensure smooth functioning of derivatives clearing.15 Continued commitment to high regulatory standards will be important to preserve hard-won financial stability gains and prevent easing of prudential regulations.

Balance Sheet Developments

34. Household and corporate debt is relatively high and has started to edge up further, although it remains below its pre-crisis peak. The cost of servicing debt for households and corporates remains relatively low, due to very low interest rates. Total credit (excluding student loans) is expanding broadly in line with GDP, although with differences across credit segments.

  • Consumer credit continues to grow rapidly, despite some moderation since 2016.16 Consumer credit is mostly unsecured with a high default rate sensitivity to income and interest rate shocks.17 The authorities have directed banks to strengthen underwriting standards for consumer loans over the last year, and survey measures show credit supply conditions have tightened since then. If rapid consumer credit growth persists, further policy measures may be warranted, including targeted increases in bank-specific capital buffers, the imposition of sectoral capital requirements, and enhanced monitoring of non-bank consumer credit providers.

  • Mortgage lending growth has been moderate, owing in part to subdued demand, as well as macroprudential measures taken in recent years.18 Despite the recent moderation in residential house price growth (and outright declines in parts of London), house prices remain high relative to incomes (Figure 9). The ratio of new mortgage loans at relatively high loan-to-income (LTI) ratios has increased somewhat in the last two years, although the share of highly indebted households remains low.19 Since 2014, mortgage lenders have been required to test whether borrowers could still afford their mortgages in a stressed rates scenario.

  • Student loans have accounted for a rising share of aggregate household debt in recent years, but these loans are typically extended by the public sector with income-contingent repayments, mitigating risks to banks.

  • Non-financial corporate balance sheets have strengthened over the last decade, with lower debt ratios and higher profitability and interest coverage ratios relative to pre-crisis levels (Figure 7). However, more recently market-based corporate borrowing has expanded rapidly supported by strong risk appetite in global markets. Foreign investments in commercial real estate and leveraged loans are significant.20 At the same time, bank exposure to risky corporate lending has declined. CRE prices remain high and have continued to rise after a short-lived dip following the EU referendum. Certain segments, including central London, seem particularly stretched.

Consumer Credit and Credit Supply Conditons

(In percent)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: Bank of England; and IMF staff calculations.Note: Lending conditions refer to the change over the past 3 months, with negative values denoting lower availability/tighter scoring criteria, as reported in the credit conditions survey and scaled betwen +-100.

35. Banks’ balance sheets have continued to strengthen. Capital and liquidity coverage ratios have increased. The authorities have raised the countercyclical capital buffer requirement from 0.5 to 1 (effective as of November 2018), consistent with their assessment that banks are in a “standard risk environment” apart from Brexit-related risks. The 2017 annual stress test conducted by the BoE suggests that the UK banking system would be resilient to deep simultaneous recessions in the UK and major economies, large falls in asset prices (including house prices), and further misconduct costs. All banks subject to the ringfencing requirements are on track to meet the January 2019 deadline, which should further strengthen the bank resolution framework. However, profitability remains a challenge. Persistently low profitability hinders the ability of banks to accumulate capital from retained earnings following an adverse shock. Profitability should, however, improve over the medium term as legacy misconduct costs dwindle and banks continue to adjust their business models. Furthermore, rising interest rates should help alleviate the pressure on interest margins.

Financial Soundness Indicators for Major UK Banks 1/

(Percent)

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Sources: Bank of England FPC Core Indicators; IMF Financial Soundness Indicators.

The coverage of banks is as defined in the Bank of England’s December Financial Stability Report, except for asset quality indicators, for which the coverage is as defined in the IMF’s Financial Soundness Indicators. Data for 2017Q3 or latest available.

36. A continued prudent approach to supervision would be important to maintain financial stability. The CCyB rate needs to be kept under review to ensure it reflects shifts in the overall risk level. A timely adoption of the Basel III final agreement together with implementation of Bank of England’s guidance on the use of hybrid models for estimating risk weights should help reduce the variability of risk weights among banks. In the meanwhile, bank-specific capital buffers should continue to be adjusted when necessary to match banks’ individual risk exposures. Potential risks related to market-based finance bear close monitoring. The authorities’ ongoing effort to collect information on leverage outside the banking system and assess potential vulnerabilities is welcome. The BoE is developing a system-wide stress simulation covering hedge funds, dealers, insurance companies and other non-bank firms as part of its work on assessing potential stability risks beyond the banking sector. The simulation should provide information on contagion risks and on the institutions’ ability to deal with sharp rises in redemptions at times of high asset price volatility. Efforts to actively monitor and mitigate cyber security risks should also continue.

Authorities’ Views

37. The authorities are committed to implementing prudential and regulatory policies after Brexit that meet or exceed international standards, independent of the outcome of the EU withdrawal negotiations. The authorities emphasized that contingency planning in the financial sector is advancing. The temporary permission regime, which is awaiting parliamentary ratification, and other legislation will ensure that EEA financial firms currently operating in the UK via a passport can continue to conduct regulated activities as normal for up to three years after exit. However, the authorities stressed the risk that cross-border derivative and insurance contracts could be affected by the loss of passporting rights in the absence of something analogous to a temporary permissions regime on the EU side. The Bank of England noted that domestic banks’ capital ratios have tripled since the end of 2007, and are at an adequate level to withstand a range of shocks, including those that could be associated with a disorderly Brexit. The authorities also noted that the macroprudential requirements on mortgage lending implemented in 2014 should mitigate risks from high household leverage. The ringfencing of banks would help ensure that banks can be resolved without resorting to public funds. The recent adoption of the MiFID II framework has helped strengthen investor protection and transparency.

D. Contingency Planning for a Disorderly No-Deal Brexit

38. Adequate capitalization, temporary permissions, and ensuring liquidity provision could help mitigate financial disruptions associated with a potential disorderly Brexit. The planned temporary permission regime for financial institutions would reduce the risk of financial services disruption for UK customers. In the event of stress in financial markets, the BoE will need to ensure that the financial system has adequate liquidity. In addition, the countercyclical buffer could be released to support bank credit supply. Of course, any relaxation of the CCyB would need to maintain confidence in the financial system and ensure an appropriate degree of resilience against future shocks. The annual stress test in 2018 should be used to gauge the strength of the banking system to withstand a combination of possible risks associated with Brexit.

39. There is some fiscal space to help smooth the adjustment if needed. The UK faces limited financing risks in the near term despite a relatively high debt burden. Gross financing needs over the forecast horizon are manageable under both the baseline and stress simulations. Market-implied default probabilities remain contained and sovereign yields are low from an historical perspective. The automatic stabilizers should be allowed to operate freely. Some additional expenditure on labor market policies could also be warranted: retraining workers and supporting their relocation across firms or sectors would help mitigate the shock to potential output. Specific measures that could be used include frontloading infrastructure spending, which would help raise the economy’s productive capacity.21 However, a permanent decline in the level of output would require an eventual fiscal adjustment to maintain sustainability. Moreover, fiscal space may become more restricted in practice if the shock to output is very large, affecting confidence and risk premia. Therefore, any policy easing should be temporary and anchored in credible medium-term fiscal consolidation plans.

Sources: CreditEdge; Haver Analytics; and IMF staff calculations.1/ EDF is Expected Default Frequency.Note: Shaded area shows the minimum and maximum of Belgium, France, Germany, Japan, Netherlands, US, and UK.

40. The appropriate monetary policy response would depend on the relative shifts of supply and demand, the change in the exchange rate, as well as the stability of inflation expectations. Consumer prices are likely to increase as trade costs go up and sterling depreciates. Output would decline, while at the same time structural unemployment may increase as firms reorient their activities to adjust to a much more restrictive trade regime. However, the implications for monetary policy are not clear cut, as the authorities may face a trade-off between inflation and output stabilization. The authorities will also need to take into account any natural tightening of financial conditions due to heightened investor risk aversion.

Authorities’ Views

41. The authorities stand ready to provide tailored responses to a wide range of shocks. The fiscal framework allows flexibility to provide temporary support in the case of large negative output shocks, but the fiscal space to respond could narrow if interest rates on public debt were to increase significantly. They also noted that the precise nature of the shock will be an important factor in determining the type of fiscal policy response that is appropriate. The authorities therefore agreed that policy space should be used judiciously, and that a permanent decline in potential output would require an eventual adjustment of revenues or spending. There was also agreement that the monetary policy response would depend on the relative shifts in supply and demand, and the magnitude of the exchange rate depreciation. They noted the current economic conditions (very little spare capacity and above target inflation) are different than those that prevailed after the referendum, which would affect their policy choices. The Bank of England believes it has enough instruments in place to ensure that the financial system has adequate liquidity.

E. Structural Reforms

42. Sustained policy efforts are needed to support growth, improve competitiveness, and help reduce income inequality and regional disparities. Productivity levels in the UK are lower than in peer economies, and productivity growth since the financial crisis has been exceptionally low. Exiting the EU could depress trend productivity further through reduced foreign investment, trade, and immigration. A multi-pronged policy approach is needed to support productivity, increase living standards and make growth more inclusive (Figure 10).22 In the near term, the key reform priority would be strengthening human capital, including through retraining, which would help support a smooth adjustment to Brexit-related structural changes.

  • Housing supply. Efforts should continue to boost housing supply, including by easing planning restrictions and reforming property taxes to encourage more efficient use of the housing stock.

  • Infrastructure. The perceived quality of UK infrastructure and public spending on infrastructure are lower than in other advanced economies (OECD 2015 and 2017). In recent years, the authorities have increased public investment in infrastructure, particularly in transport, with plans for further increases over the medium term. In addition, the institutional framework for selection and oversight of infrastructure projects has been strengthened significantly. Nevertheless, further efforts would be needed to close the infrastructure gap with peer economies.

  • Human capital. UK students rank low on tests of basic numeracy and literacy despite relatively high average education spending in percent of GDP as well as per pupil. Last year’s introduction of T-level technical qualifications and reforms to funding for apprenticeships should help reduce the skills gap. It will be important to monitor and evaluate the effectiveness of these programs once they have been in place for some time. Recent initiatives to increase the basic skills of high-school graduates could also help reduce income inequality and foster social mobility.

  • Research and development. Public and private spending on research and development in the UK is relatively low compared to the OECD average. The government’s pledge to increase public investment in R&D programs is a step in the right direction.

  • Decentralization of governance arrangements. Fiscal centralization is high in the UK relative to other countries. A greater role for local decision-making has the potential to better tailor policies to local economic conditions, if equalization mechanisms are in place to ensure that the subnational governments have adequate resources to meet the responsibilities devolved to them.23

43. Boosting economic opportunities for women would promote growth and equity. The female participation rate in the UK, at 74 percent, is already relatively high by advanced economy standards. Recent government initiatives have sought to increase it further by improving government support for childcare costs and doubling the free childcare available to 3- and 4-year-olds of eligible working parents. The government has also introduced free childcare for disadvantaged children aged 2. Nevertheless, fully closing the participation rate gap would boost output by around 5 to 6 percent in the long run. Policies to facilitate job sharing and compressed work schedules could be helpful in this regard. Efforts should also focus on measures to close the gender pay gap (which stands at 10 percent on average for full-time employees) and to increase representation of women in senior positions and in corporate boards, where they remain relatively few in number. Recently-enacted legislation requiring larger firms to make public data on gender pay gaps has helped focus attention on pay disparities.

Labor Force Participation by Gender in OECD Countries, 1994–2016

(in percent)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: OECD; and IMF staff calculations.

44. Brexit is likely to reshape the structure of the UK economy and policies could play a role in facilitating the transition. The ultimate impact will depend on the nature of the final agreement and may take many years to fully materialize. Nevertheless, rising trade barriers with the EU are likely to affect some industries more than others, resulting in a reallocation of resources across sectors post-Brexit (Box 4). Although UK labor markets are very flexible, which would help the adjustment (OECD, 2014), productivity could suffer further from Brexit-induced sectoral adjustments.24 Policies should seek to support workers and not particular jobs or sectors. For instance, increased use of active labor market policies, including support for re-training, such as the National Retraining Scheme, could help facilitate the adjustment for both low-skilled and highly-specialized workers. 25 Evaluations of the effectiveness of job-search support policies should take into account the sustainability and quality of job matches, not only the time it takes to find a match. Moreover, policies that promote entrepreneurship, higher investment in R&D, and reforms to promote housing supply and mobility could increase productivity and facilitate human capital accumulation.

Expenditure in Active Labor Market Measures

(Current prices, constant PPP, per unemployed worker)

Citation: IMF Staff Country Reports 2018, 316; 10.5089/9781484384589.002.A002

Sources: OECD; and IMF staff calculations.

Authorities’ Views

45. The authorities agreed with staff’s view on the key structural reform priorities. They noted that a comprehensive strategy is underway for boosting productivity based on supporting long-term investment in physical, human and intellectual capital. A £31 billion National Productivity Investment Fund has been created, targeting investments in transport, housing, digital, and research and development. The expansion of infrastructure spending would be done at a gradual pace to contain any cost inflation and get the best value for money. Infrastructure investment is targeted to increase by over 50 percent from 2012/13 to 2020/21, and the fiscal remit for the National Infrastructure Commission aims for sustained public infrastructure investment of 1 to 1.2 percent of GDP over the long-term. The new system for funding apprenticeships and the recently announced reforms to technical education should increase students’ skills and facilitate job matching. The authorities agreed that increased use of active labor market policies, including support for retraining such as the National Retraining Scheme could help smooth the flow of workers both geographically and across economic sectors post-Brexit. The government recently announced it intends to pilot extended performance measures in the evaluation of its job programs, including factors such as length of the employment spell and earnings progression while in work.

F. Corporate Transparency and Anti-Corruption Efforts

46. Corporate transparency continues improving. Measures to verify beneficial ownership information of UK companies in the publicly available People with Significant Control (PSC) register are being developed and implemented. Financial institutions will be required to report discrepancies in the PSC register. Strong enforcement actions for breaches of the requirements under the PSC and private trust registers will contribute to ensuring that information contained in such registers is timely and accurate. The proposal for a register of overseas legal entities owning UK real estate is also welcome and should include verification measures. The new Office for Professional Body Anti-Money Laundering Supervision is expected to improve consistency of AML supervision in the accounting and legal sectors, especially for firms that provide trust and company services. The UK authorities’ commitment to supporting British Overseas Territories (BOTs) in establishing public registers of beneficial ownership of companies is welcome. The agreements allowing the rapid exchange of information of companies registered in Crown Dependencies and BOTs should be extended to cover trusts.

47. Anti-foreign bribery enforcement has strengthened in recent years. The report by the OECD Working Group on Bribery in International Business Transactions, which for the UK is the basis of staff’s assessment, commends the UK’s enforcement efforts and political commitment to fighting foreign bribery. 26, 27 The positive assessment is due to legislative reforms, such as deferred prosecution agreements and the effective approach taken by the Serious Fraud Office (SFO) to investigate and resolve cases. Channels for whistleblowing and detection capabilities were also improved, including through enhanced intelligence analysis by the SFO. Individuals and companies have been found criminally liable, civil remedies have been applied and administrative sanctions imposed.

48. The OECD Working Group report calls on the UK to build on the current work to enhance the effectiveness of enforcement. Efforts should focus on: (i) maintaining the role of the SFO in foreign bribery cases; (ii) further improving interagency cooperation and ensuring the safeguard of the independence of investigations and prosecutions; (iii) improving coordination of law enforcement between England, Wales, and Scotland and improving Scotland’s enforcement capacity; (iv) enhancing the UK’s AML reporting framework to improve detection of foreign bribery; (v) strengthening engagement with the CDBOT regarding the detection and enforcement; and (vi) conducting a comprehensive review of Her Majesty’s Revenues and Customs capacity to detect and report foreign bribery. Fund staff agrees with these recommendations and urges the UK to move forward to implement them.

Authorities’ Views

49. The authorities welcomed the IMF assessment of efforts to tackle issues related to beneficial ownership and the supply side of corruption. In addition to the PSC and the private trust registers, they noted they are conducting public consultation for the register of overseas legal entities owning UK real estate. In parallel, beneficial ownership information is now a condition of awarding contracts that involve central government procurement and meet certain criteria or thresholds. They are also implementing the OECD Phase 4 recommendations. For example, they increased the budget of the SFO and created a new National Economic Crime Centre which will improve cross-government intelligence sharing and cooperation.

Staff Appraisal

50. Economic activity has moderated since the referendum in June 2016. Net exports were supported by weaker sterling and strong external demand. However, above-target inflation following the sharp post-referendum depreciation reduced real income and consumption growth. Business investment has been lower than would be expected in the context of robust global growth and favorable financing conditions. Despite the slowdown in growth, the employment rate has risen to a record high and slack in the economy is limited.

51. Growth is expected to remain moderate in the near term, although there are significant risks. Investment would remain constrained as long as Brexit uncertainty weighs on firms. With the economy operating at full employment and household saving already at a very low rate, consumption growth will be broadly in line with subdued real income growth. Net exports are expected to continue to make a positive contribution to growth. The baseline forecast is conditional on a timely agreement with the EU including on a trade pact covering goods and some services, and a relatively smooth Brexit process thereafter.

52. Leaving the EU without an agreement is the most significant near-term risk to the UK economy. A disruptive departure without an implementation period could have serious negative economic consequences. While all likely Brexit outcomes will entail costs for the UK economy by departing from the frictionless single market that now prevails, an agreement that minimizes the introduction of new tariff and nontariff barriers would best protect growth and incomes in the UK and EU. Close cooperation and coordination with the EU to prevent disruptions and mitigate risks will be important to achieve a smooth transition.

53. Monetary policy should respond flexibly to data developments in an environment of heightened uncertainty. While the inflationary impact of past sterling depreciation continues to fade, unit labor costs are firming in the context of a tight labor market. If domestic inflation surpasses the level consistent with the 2-percent target, further gradual tightening of monetary policy would be warranted. However, if negative economic shocks depress domestic demand relative to supply, accommodative conditions should be maintained. The reduction in the Bank of England’s balance sheet should commence once the policy rate has reached a level from which it can be cut materially in the event of a demand slowdown.

54. Steady fiscal consolidation remains critical to comply with the government’s fiscal framework, build buffers against future shocks, and help reduce the current account deficit. The recently-announced increase in public health spending should be financed from new revenue sources and/or offsetting spending cuts elsewhere in the budget. Brexit-related effects would add to the rising strain on public finances related to population aging. To mitigate age-related spending increases, the authorities should explore opportunities for further efficiency gains in health care provision and eliminate the “triple lock” on public pensions. Absent a fundamental rethinking of the size and role of the public sector, revenue measures would need to occupy a more prominent place in deficit reduction efforts going forward.

55. A continued prudent approach to supervision is crucial in a context of relatively easy financing conditions and heightened risks related to Brexit. Household and corporate leverage have started to edge up, although they remain below pre-crisis levels. Consumer credit continues to rise faster than income, despite recent tightening of underwriting standards. Further policy action may be needed if high rates of growth persist, including additional increases in bank-specific capital buffers and steps to enhance the oversight of nonbank financial institutions. Regulatory and supervisory cooperation between UK and EU authorities will be crucial to maintaining the integrity of cross-border financial transactions after Brexit. As suggested in the recent Euro Area FSAP, the EU and UK authorities should work together to ensure legal continuity in insurance and derivative contracts and proper data sharing to avoid cliff-edge effects. Continued commitment to high regulatory standards is essential to preserve hard-won financial stability gains.

56. In a disorderly no-deal Brexit scenario, policies should seek to safeguard macroeconomic and financial stability. In the event of financial market disruption accompanied by sharp declines in asset prices, the Bank of England would need to ensure that the financial system has adequate liquidity. The fiscal framework provides flexibility to support the economy, for example through bringing forward infrastructure spending. However, the space to respond could narrow if the shock were to significantly raise interest rates on public debt. Any easing of fiscal policy should be targeted and embedded in a credible medium-term fiscal consolidation plan. A permanent shock to output would require an eventual adjustment of revenues or spending.

57. Further sustained policy efforts are needed to support productivity and make growth more inclusive. The plan to increase public infrastructure investment over the medium term is welcome. Continued focus on policies to increase human capital is also critical. Improving economic opportunities for women by facilitating flexible work arrangements and closing the gender pay gap would promote growth and equity. Brexit will lead to important shifts in the structure of the UK economy and policies could play a role in facilitating the transition. Policies should seek to support workers and not particular jobs or sectors. Options include support for re-training, policies that promote entrepreneurship, higher investment in research and development, and reforms to promote housing supply and mobility.

58. Efforts to improve corporate transparency and enforcement against foreign bribery should continue. Measures to verify beneficial ownership continue to be developed and implemented. Ensuring consistent and effective AML supervision of TCSPs is critical to mitigating ML abuse. Enhancing continued exchange of information on companies and trusts with the CDBOT is important. Efforts to combat the supply side of corruption are welcome, and further enforcement including in CDBOT is encouraged.

59. It is recommended that the next Article IV consultation be held on the standard 12-month cycle.

Table 1.

United Kingdom: Selected Economic Indicators, 2014–2019

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Sources: Bank of England; IMF’s Information Notice System; HM Treasury; Office for National Statistics; and IMF staff estimates.

Based on ONS preliminary estimate of GDP for 2017Q4.

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. English housing associations are re-classified from the public to the private sector starting in FY2017.

In percent of potential output.

As of September 2018.

Table 2.

United Kingdom: Medium-Term Scenario, 2013–23

(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 hour worked.

In percent of total household available resources.

Table 3.

United Kingdom: Statement of Public Sector Operations, 2010/11–22/23 1/

(Percentage change, 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.

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

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

Table 4.

United Kingdom: Balance of Payments, 2013–23

(Percent of GDP)

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