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UK Prime Minister David Cameron and HSBC Group Chairman Stephen Green, who has been nominated as the Minister of State for Trade and Investment, Sept 08, 2010.
The IMF said today that the
UK economy is on the mend. Economic
recovery is underway, unemployment has stabilized, and financial sector health
has improved. The Fund forecasts real GDP (gross domestic product) growth of 2%
in 2011 and supports the fiscal tightening program.
The IMF said government’s strong and credible
multi-year fiscal deficit reduction plan is essential to ensure debt
sustainability. The plan greatly reduces the risk of a costly loss of confidence
in public finances and supports a balanced recovery. The fund says fiscal
tightening will dampen short-term growth but not stop it as other sectors of the
economy emerge as drivers of recovery, supported by continued monetary stimulus.
Upside and downside risks around this central scenario of moderate growth and
gradually falling inflation are balanced. Monetary policy will need to be nimble
if risks materialize, and fiscal automatic stabilizers should operate freely.
Meanwhile, the UK authorities should continue to provide leadership and build
support for ambitious global reform of financial regulation. Ensuring a smooth
transition to a new supervisory architecture at home will also be important to
secure a safer post-crisis environment.
Outlook and risks
Economic recovery is underway, but
will likely proceed at a moderate pace as the economy undergoes a difficult but
are likely to remain thriftier than before the crisis but will be in a
position to gradually raise their consumption as labor markets recover.
are beginning to draw on their strong financial positions and increase
investment as the demand outlook strengthens.
In the external sector, past
sterling depreciation - - which has put the currency broadly in line with
fundamentals - - has so far mainly boosted exporter margins rather than
volumes. Over time, however, higher profits should encourage increased
production in export and import-competing sectors.
This progressive strengthening of private
and external demand should underpin a moderate-paced recovery, even as the
public sector retrenches. The central scenario envisages real GDP growth of
2% in 2011, rising gradually to 2½% in the medium term.
Barring unforeseen shocks, CPI
inflation should fall back to target by early 2012.
Although recent inflation outturns have exceeded the 2% target, this overshoot
reflects price level shocks related to the January 2010 VAT increase, rebounding
global commodity prices, and continued pass-through from earlier sterling
depreciation. Another VAT increase in January 2011 will keep headline inflation
above target next year. But over time the existing margin of spare capacity,
along with fiscal tightening, will impart a significant disinflationary impulse.
As a result, inflation should gradually revert to target as temporary effects
dissipate and economic slack keeps underlying wage and price pressures in check.
Upside and downside risks are
balanced, but uncertainty around the central scenario is considerable:
On the upside, the fund says expansionary
impulses from very low real interest rates, past sterling depreciation, and
the ongoing recovery of global demand could be greater than expected,
boosting the UK economy onto a faster-than-expected growth path. This
scenario would likely entail higher global commodity prices and stronger
However, downside risks are also sizeable,
given the continued fragility of confidence, still-strained balance sheets
among households and banks, signs of renewed housing market weakness, and
the possibility that headwinds from fiscal consolidation could turn out to
be more powerful than expected. Although it is unlikely and not unique to
the UK, an adverse scenario where major new shocks - - arising from either
external forces or domestic ones—trigger another extended contraction in
output cannot be ruled out.
"There's a great deal of uncertainty at the moment... we really are in for a very difficult time ahead,"Lord Karan Bilimoria, founder & chairman of Cobra Beer, told CNBC Monday when discussing the outlook for the UK:
The policy agenda
The policy challenge going forward
is to promote a balanced and sustainable recovery while healing post-crisis
With record-high budget deficits, credible
fiscal tightening is essential to preserve confidence in debt
sustainability and regain fiscal space to cope with future shocks.
To offset this contractionary impulse and
keep inflation close to target over the policy horizon, a highly
accommodative monetary stance remains appropriate, supporting private
demand and net exports.
At the same time, financial sector
reform is crucial to move to a safer system that features stronger
capital and liquidity buffers, supported by tighter regulation and
At the international level, the effectiveness of
efforts by the UK authorities in these areas will be amplified if they are
complemented by coordinated EU and multilateral action to strengthen financial
regulation and rebalance global demand toward more sustainable external
positions across countries.
Ensuring fiscal sustainability
The government’s strong deficit
reduction plan will ensure fiscal sustainability.
The Fund says the fiscal mandate of balancing the cyclically-adjusted current
budget by 2015/16 is appropriately ambitious. The plan’s credibility has been
bolstered by a frontloaded path that achieves the mandate one year early and by
a suitable mix of concrete spending and revenue measures. The consolidation plan
and implementation of early measures to tackle the deficit - - one of the
highest in the world in 2010 - - greatly reduces the risk of a costly loss of
confidence in fiscal sustainability and will help rebalance the economy. These
benefits outweigh the expected costs in terms of adverse effects on near-term
growth. The IMF says market reaction to the adjustment plan has been positive.
Nonetheless, the magnitude of the growth headwinds from fiscal adjustment is
uncertain and could be different than anticipated. In this case, the free
operation of automatic stabilizers in both directions, alongside further support
from monetary policy, provides an important safeguard even as structural
The upcoming spending review
provides an opportunity to further strengthen the composition of adjustment.
Though this review will undoubtedly involve many difficult choices, the IMF says
more emphasis should be given to reducing public sector compensation premia and
achieving savings in benefits and transfers through better targeting. This would
mitigate the growth effects of adjustment - - because reducing transfers to the
less needy may have a smaller effect on consumption - - and help shield the
Entitlement reforms would also help
cement long-term fiscal sustainability. Potential
measures in this area include bringing forward the planned increases in the
statutory retirement age for state pensions and gradually aligning the
generosity of public sector pensions with those for their counterparts in the
private sector. Such reforms would have a limited adverse effect on aggregate
demand now, but yield significant fiscal savings over the long run, thereby
boosting the credibility of the government’s adjustment package. The initiatives
launched by the government to review reform options for state and public sector
pensions are therefore welcome.
The Fund says the establishment of
a new independent Office for Budget Responsibility (OBR) is a welcome step
toward strengthening the budget process.
Addressing deficiencies in the previous fiscal framework, the tasks envisaged
for the new independent office - - including to provide the macroeconomic and
fiscal forecasts for the budget and to assess fiscal sustainability and
compliance with the fiscal mandate - - are apt. The OBR complements the
government’s commitment to fiscal discipline by enhancing the transparency and
credibility of the budget process and helping inform policy decisions. As the
role and remit of the permanent OBR are finalized, it will be important to
underpin its independence through an arms-length relationship with Treasury,
full-access rights to pertinent information, and multi-year budgets. The current
forward-looking fiscal mandate is an appropriate guide for the transition to a
more sustainable fiscal position, but in due course should be replaced with a
more permanent forward-looking fiscal rule that would continue to be monitored
by the OBR.
Maintaining monetary stimulus
Unprecedented monetary easing has
helped restore confidence and bolster the recovery.
The IMF says near-zero policy rates have played a key role in supporting demand
and facilitating balance sheet repair. The Bank of England’s large-scale asset
purchases have provided additional stimulus: although the precise impact of
quantitative easing on aggregate demand remains hard to quantify, there is clear
evidence that it has lowered bond yields and boosted asset valuations, thereby
shoring up market confidence, household net wealth, and corporate credit supply.
Meanwhile, medium-term inflation expectations have remained well-anchored.
The current monetary stance and
data-dependent approach to next steps is appropriate.
With inflation projected to fall back to target over the policy horizon, the
Bank of England’s accommodative stance reflects the need to maintain overall
policy stimulus as fiscal tightening takes hold and financial intermediation
normalizes only gradually. However, near-term adjustments might become necessary
in response to incoming data. If the recovery were to weaken and increase
disinflationary pressure, asset purchases should resume. Conversely, the central
bank must stand ready to start a gradual tightening if output recovers apace and
inflation continues to surprise on the upside. Developments in labor costs,
other input prices, and inflation expectations warrant particularly close
Moving to a safer financial system
The Fund says the health of the
banking sector has improved over the last year.
All major banks have raised capital and lowered leverage. For the system,
earnings have been boosted by lower-than-expected impairment charges, wider
lending margins, and higher investment banking revenue. The recent EU-wide
stress tests and associated disclosure, complementary to the UK’s own earlier
stress-testing exercise, confirmed the relatively good health of UK banks,
facilitating their efforts to tap longer-term funding markets.
Nonetheless, important challenges
remain. The ongoing adjustment of bank balance
sheets needs to continue, as public support schemes taper off and regulatory
requirements tighten. Meanwhile, uncertainty about the sustainability of bank
profits and the quality of their assets, especially some banks’ exposure to
commercial real estate, remains significant. Faced with such uncertainty, banks
have stayed cautious about extending new credit. Tight credit supply, in turn,
could curb the pace of recovery once credit demand, which is currently weak,
In view of this environment,
continued progress is needed to enhance financial sector resilience and reduce
risks to the economy and taxpayer. Toward these
The IMF says capital buffers should be
strengthened further, notably by restraining dividend payouts and remuneration
budgets, taking into account bank-specific circumstances. Although higher
capitalization will decrease expected returns on equity in the banking sector,
this should be compensated by lower risks for bank stakeholders and society at
large. Larger capital buffers will also enhance banks’ ability to raise
longer-term funds at reasonable costs and maintain adequate credit supply to the
private sector at all times.
The Fund says crisis-related public interventions
should be unwound in line with initial program design to gradually reduce
taxpayer risk and restore private sector responsibility. Against this backdrop,
supervisors need to keep up the pressure on banks to develop robust new funding
models based upon a sound mix of simpler and more transparent instruments.
Progress in this direction would benefit from timely clarification of how
international and EU regulators will treat different capital and funding
instruments in the future.
Beyond these efforts, the case for deeper
structural changes to the UK financial sector needs to be examined. The public
debate on possible reforms, informed by the Independent Commission on Banking,
is welcome, today's report says.
Building on the recent Basel III
and Financial Stability Board proposals, the Fund says the UK authorities should
continue their constructive efforts to secure an ambitious international package
of regulatory reform and rigorous implementation of this package in the EU:
The UK is home to a number of very large
financial institutions. Thus, the authorities have rightly emphasized the
need for concrete tools, such as capital and liquidity surcharges, to
address the resulting systemic risk. They should continue to provide
intellectual leadership in this debate while cooperating closely with their
international partners to reach agreement on a suitable set of reforms.
In the same vein, the IMF says additional
work is needed to facilitate the resolution of complex, cross-border
financial institutions, as envisaged under the authorities’ pilot exercise
on “living wills.” The UK’s 2009 Banking Act has provided an
effective national special resolution regime for banks. However, greater
international cooperation is indispensable to develop credible policy tools
for handling the failure of systemically important entities with complex,
The development of macroprudential
instruments to mitigate the amplitude of credit cycles is another key policy
priority. The IMF says the creation of a
Financial Policy Committee (FPC) with an explicit macroprudential mandate is a
welcome step. In their relevant consultation document, the authorities have
rightly laid out a wide range of tools that would give the FPC flexibility to
respond to the build-up of risks. However, more work on the calibration of these
tools will be required. To be effective, some macroprudential measures will also
need to be coordinated closely with regulators in other countries, notably
within the EU.
Continued emphasis on proactive
microprudential oversight is also critical as the UK moves to a new regulatory
architecture. The Fund says the new setup should
facilitate the integration of micro- and macroprudential oversight, but
institutional changes alone are no guarantee for superior outcomes. It will thus
be crucial to continue enhancing the more intrusive, judgment-based, and
strategic approach to supervision adopted since the crisis. In this context:
The Prudential Regulation Authority should
have the power to supervise and, if necessary, give formal directions at the
financial holding company level in order to enhance consolidated
Adoption of a “prompt corrective action”
regime would further strengthen the supervisor’s capacity to address
emerging risks at an early stage.
Prudential oversight should be supported by
market discipline. A useful tool in this regard would be the regular public
disclosure by the supervisor of non-confidential firm-level prudential
The tightening of banking sector regulation
might cause risks to migrate into less regulated parts of the financial
system. A critical task for the FPC, therefore, will be to identify such
risk migration and ensure a commensurate widening of the regulatory
The IMF staff will conduct a
comprehensive financial system stability assessment for the UK in 2011.
This assessment, to be prepared under the IMF’s “Financial Sector Assessment
Program” (FSAP), will provide an opportunity to further review key issues in
the financial sector.
The Fund said with steadfast fiscal adjustment,
forward-looking monetary policy aimed at achieving the inflation target, and
gradual implementation of strong financial sector reforms, economic fundamentals
should strengthen and establish the basis for sustainable recovery.