Public Information Notice No. 02/22

Public Information Notice: IMF Concludes 2001 Article IV Consultation with the United Kingdom

March 7, 2002

On March 4, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United Kingdom.¹

Background

The United Kingdom has experienced nine years of sustained noninflationary output growth, the longest such expansion in more than 30 years. Since the 1991-92 recession, output has increased by an average of almost 3 percent a year. Inflation has declined from a peak of 9½ percent in late 1991 to about 2 percent, and on a harmonized basis was the lowest in the EU in 2001. At the same time, the unemployment rate has halved during the 1990s, falling to about 5 percent last year—the lowest in over a quarter century. The current account deficit averaged 1¾ percent of GDP in 1998-2001, compared with a deficit of 5 percent of GDP in 1989.

In 2001, the U.K. economy grew faster than any other G-7 economy. Despite the slowdown in world demand, output grew by 2.4 percent reflecting strong domestic demand. Private consumption remained buoyant, fueled by several years of strong earnings and employment growth, low interest rates, and rising housing wealth, which largely offset the adverse impact of lower equity prices on consumer spending. Following several years of robust growth, private investment was hit by the downturn in the information and telecommunications sector and contracted sharply in the second half of the year. With both exports and imports falling, the trade balance continued to make a negative contribution to growth. Inflation averaged about 2 percent and the unemployment rate edged up slightly to reach some 5.2 percent by year end.

Nevertheless, after a decade of continuous expansion, some potential imbalances have emerged. Beginning in late 1996, as sterling appreciated in real effective terms, growth has been sustained primarily by domestic demand and net exports have weakened. Moreover in the last year, private consumption and public spending, rather than private investment, have been the main driving forces. Household saving has dropped and private sector debt ratios have surged. House prices have continued to rise strongly while mortgage equity withdrawals have approached the levels of the1980s.

At the structural level, raising productivity has been a key issue. Productivity in the United Kingdom is still significantly lower than in other G-7 countries, even though the gap has narrowed during the 1990s. Empirical evidence suggests that the main cause is a gap in public and private human and physical capital. Years of underinvestment have also led to deterioration in the quality of public services, which has been a focus of recent political debate.

The fiscal position has been strengthened significantly in recent years. The cyclically-adjusted overall balance swung from a deficit of 5½ percent of GDP in FY1993/94 to a surplus of 1½ percent of GDP in FY2000/01, while the public net debt ratio fell from 44½ percent of GDP at end-1996 to 31½ percent of GDP at end-2001. The November pre-budget report (PBR) envisages a sizeable fiscal impulse in FY2001/02, with the cyclically-adjusted overall fiscal balance projected to shift from a surplus of 1.6 percent of GDP in FY2000/01 to a deficit of 0.3 percent of GDP in FY2001/02, mostly due to sizeable spending increases (mainly on infrastructure investment, health, and education) and lower tax revenues reflecting the decline in profits of financial companies as well as oil and equity prices. With the revenue shortfalls expected to be temporary, the deficit is projected to return to the originally envisaged level of about 1 percent of GDP by the end of the forecast horizon.

The inflation-targeting framework was substantially strengthened in 1997 through the granting of operational independence to the Bank of England to pursue a symmetric 2½ percent inflation target. This action, together with improvements in transparency, has helped anchor inflation expectations. Between February and November 2001, the Bank responded preemptively to the weakening external environment with a cumulative 200 basis point interest rate cut. These rate cuts helped support consumer confidence, as well as household borrowing and house prices—the latter rising, on average, by 10½ percent in 2001. Since November 2001, the Bank has kept interest rates unchanged noting that the risks were finely balanced between doing too little to support domestic demand—and so allowing inflation to move further below target—and doing too much—possibly creating difficulties in meeting the inflation target further out, including by allowing excessive private debt accumulation.

Executive Board Assessment

Executive Directors commended the authorities for the impressive performance of the U.K. economy as reflected in nearly a decade of noninflationary output and employment growth. Directors noted that this performance owes much to sound macroeconomic policies, the unwavering observance of a strong policy framework, and sustained structural reforms. The public finances, guided by the fiscal rules, are on a sound footing; the monetary policy framework has anchored inflation expectations at the 2½ percent target; and sustained labor market and welfare reforms have facilitated a marked reduction in unemployment without triggering wage pressures.

Looking ahead, Directors agreed that the current slowdown in output growth is likely to be relatively brief owing to the fiscal stimulus imparted by the present budget, the delayed effects of the monetary easing in 2001, and the recovery in external demand projected for later this year. They noted that the outlook is, nonetheless, subject to risks. On the downside, the global recovery could be weaker than anticipated. The investment slowdown could turn out to be deeper, particularly given low manufacturing profitability, which a number of Directors related to the continued high value of the pound sterling. Moreover, asset prices could decline unexpectedly. Directors noted that the potential imbalances that have emerged in the last few years—particularly house price increases, and rising private sector debt ratios—although less pronounced than in the 1980s, warrant careful watching. On the upside, private consumption growth might not decelerate as anticipated. Against this background, Directors agreed that the government's policy framework is appropriate for the present conjuncture, with fiscal policy remaining oriented towards the medium term, monetary policy being the instrument of choice to respond to cyclical price pressures, and structural policies aiming at increasing productivity.

Directors noted that policy predictability will remain key to preserving the credibility of the fiscal framework. While supporting the full operation of the automatic stabilizers, they stressed that it will be important not to raise the structural deficit beyond the path envisaged in the November pre-budget report. In recommending continued fiscal prudence, some Directors also cautioned that the recent revenue shortfall experienced this year may not prove as temporary as expected, and that an excessive push on demand could require sharper increases in interest rates in the future. Several Directors suggested that the predictability of budget policies could be further enhanced by lowering the 40 percent net public debt-to-GDP ceiling to a level closer to the current ratio, but several other Directors saw no pressing need to change the fiscal rules, considering that stability in the framework has served fiscal policies well.

Directors noted that the fiscal credibility earned from the strict adherence to a sound policy framework has greatly improved the UK's flexibility to respond to new challenges. In this regard, they welcomed the authorities' plans to increase public investments in education and infrastructure from their current low levels. Given the rapid increase in outlays over the coming years that existing plans already encompass, Directors stressed that any additional spending should be undertaken only if it is based on a clear-cut economic justification, and if risks of spending inefficiencies are adequately addressed. They welcomed the recent measures to improve the efficiency and effectiveness of public services, and encouraged the authorities to continue the ongoing strengthening of the expenditure management framework.

Directors underscored that an increase in public expenditure beyond current plans would need to be funded by offsetting tax measures, and they noted, in this regard, the public debate over possible tax increases. To preserve the neutrality and efficiency of the U.K. tax system, they considered that broadening the base of existing taxes by eliminating remaining exemptions would be preferable to raising tax rates. In this context, several Directors suggested that the authorities should consider the possible elimination of zero-rating under the VAT. In addition, it was suggested that a broader application of user fees for public services would promote the efficient use of resources. Directors noted that, in both cases, targeted transfers could offset any resulting adverse impact on the poor.

Directors commended the authorities for their skillful management of monetary policy, including their prompt response to the deterioration of the economic outlook in 2001. Looking ahead, they agreed that, given the balanced risks to the outlook, the authorities should continue to monitor developments closely, and be prepared to adjust policy in either direction, consistent with the symmetric nature of the inflation targeting framework. A number of Directors noted that, in considering any further monetary easing, the authorities should be especially mindful of the risk of an excessive rise in debt ratios with the attendant possibility of a disruptive demand correction if consumers retrenched in the face of rising indebtedness.

Directors considered the banking system to be sound, noting that high profitability and capitalization levels provide an adequate buffer if asset quality were to deteriorate unexpectedly. Continued vigilance will help to ensure that capitalization and provisions remain appropriate, and that other parts of the financial system, including insurance, also remain sound. In this regard, Directors stressed the importance of close cooperation between the Financial Services Authority (FSA), the Bank of England, and the Treasury to ensure systemic stability, and they welcomed the assumption by the FSA of full regulatory powers under the new Financial Services and Markets Act as the single statutory regulator for financial services. Directors welcomed the authorities' decision to participate in a Financial Sector Assessment Program (FSAP) in 2002. They also commended their strong commitment and comprehensive efforts to combat money laundering and the financing of terrorism.

Directors endorsed the authorities' medium-term objective of raising productivity and growth prospects through targeted structural reforms aimed at identifiable market failures. They welcomed the drive to strengthen the competition regime and improve land use regulation. Directors also agreed that efforts to promote savings through pension reforms and various tax-supported saving vehicles should enhance long-term economic growth, but they saw scope for simplifying the range of publicly-supported saving options and improving their efficiency and targeting.

Directors commended the authorities for their consistent implementation over many years of labor market and welfare reforms that contributed to greater labor market flexibility and high rates of employment. They welcomed ongoing efforts aimed at addressing remaining challenges, notably the reduction of inactivity among the unskilled and of child poverty. Directors also encouraged the continued streamlining of work incentives by reforming housing benefits, particularly for the working-age population.

Directors noted that the decision on whether to join European Monetary Union (EMU) remains a key issue for the United Kingdom. They considered that the five economic tests announced in 1997 continue to be broadly appropriate to guide this decision, and welcomed the initiation of the technical work on the methodology to be used in evaluating the five tests.

Directors praised the authorities' commitment to write off the debt of the poorest countries in the context of the HIPC Initiative and to increase official development assistance (ODA). They encouraged the authorities to continue their efforts towards reaching the U.N. target for ODA of 0.7 percent of GNP.

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