A. Economic Outlook

6. Views on the short-term outlook were sanguine. BOE officials, the private consensus, and staff expected output growth to settle at about 2½ percent. Private consumption growth should be underpinned by continued solid earnings growth, largely offsetting the lagged effects of last year’s interest rate increases and a projected modest drop in house prices. Business investment was projected to accelerate somewhat, with support from robust corporate profitability more than offsetting the drag from high leverage. Export growth was expected to pick up, although remain below import growth. Treasury officials, who saw coincident indicators as suggesting that output was still about 1 percent below potential, expected quarterly growth to increase, supported by stronger external demand and government spending. They projected output growth in 2005 at 3¼ percent.

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Household’s Debt Servicing Costs

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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Corporate Leverage

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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Medium-Term Scenario

(Percentage change, unless otherwise indicated)

^1/Contribution to the growth of GDP.

^2/In percent of GDP.

^3/In percent of labor force; based on Labor Force Survey.

Medium-Term Scenario

(Percentage change, unless otherwise indicated)

			2003	2004	2005	2006	2007	2008	2009	2010
Real GDP			2.2	3.1	2.6	2.6	2.3	2.2	2.2	2.2
	Domestic demand		2.5	3.8	2.9	2.7	2.4	2.2	2.1	2.1
		Private consumption	2.3	3.3	2.5	2.3	2.2	2.1	2.0	2.0
		Government consumption	3.5	4.5	3.0	3.0	2.5	2.0	2.0	2.0
	Fixed investment		2.2	6.1	4.9	4.0	2.9	2.7	2.7	2.6
		Public	23.1	11.7	17.8	11.2	5.6	4.6	4.1	4.1
		Residential	9.0	8.0	-6.6	-0.5	0.7	0.9	1.2	1.2
		Business	-1.8	4.8	6.0	3.8	3.0	2.7	2.7	2.7
Net exports 1/			-0.3	-0.8	-0.5	-0.3	-0.2	-0.1	0.0	0.0
Current account 2/			-1.7	-2.4	-2.5	-2.5	-2.5	-2.5	-2.5	-2.4
CPI inflation			1.4	1.3	1.5	1.8	2.0	2.0	2.0	2.0
Output gap			-0.8	-0.2	0.0	0.0	0.0	0.0	0.0	0.0
Unemployment rate 3/			5.0	4.8	4.6	4.6	4.6	4.6	4.6	4.6

^1/Contribution to the growth of GDP.

^2/In percent of GDP.

^3/In percent of labor force; based on Labor Force Survey.

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Medium-Term Scenario

(Percentage change, unless otherwise indicated)

			2003	2004	2005	2006	2007	2008	2009	2010
Real GDP			2.2	3.1	2.6	2.6	2.3	2.2	2.2	2.2
	Domestic demand		2.5	3.8	2.9	2.7	2.4	2.2	2.1	2.1
		Private consumption	2.3	3.3	2.5	2.3	2.2	2.1	2.0	2.0
		Government consumption	3.5	4.5	3.0	3.0	2.5	2.0	2.0	2.0
	Fixed investment		2.2	6.1	4.9	4.0	2.9	2.7	2.7	2.6
		Public	23.1	11.7	17.8	11.2	5.6	4.6	4.1	4.1
		Residential	9.0	8.0	-6.6	-0.5	0.7	0.9	1.2	1.2
		Business	-1.8	4.8	6.0	3.8	3.0	2.7	2.7	2.7
Net exports 1/			-0.3	-0.8	-0.5	-0.3	-0.2	-0.1	0.0	0.0
Current account 2/			-1.7	-2.4	-2.5	-2.5	-2.5	-2.5	-2.5	-2.4
CPI inflation			1.4	1.3	1.5	1.8	2.0	2.0	2.0	2.0
Output gap			-0.8	-0.2	0.0	0.0	0.0	0.0	0.0	0.0
Unemployment rate 3/			5.0	4.8	4.6	4.6	4.6	4.6	4.6	4.6

^1/Contribution to the growth of GDP.

^2/In percent of GDP.

^3/In percent of labor force; based on Labor Force Survey.

7. The fundamental question differentiating these projections was where the economy is relative to capacity constraints. In the Treasury’s view, a key indicator of excess capacity was the decline in average hours worked per week over the past three years. Staff, however, viewed the drop in hours worked as more a secular than cyclical development—especially because the recent change is largely accounted for by an increase in part-time employment, which surveys suggest has been voluntary. Staff argued that the historically low unemployment rate and rising survey measures of capacity utilization, as well as its production-function-based estimate of the output gap, suggested that the economy was operating in the neighborhood of full capacity, in line with the BOE’s view and the private consensus view. Nevertheless, staff acknowledged important uncertainties about supply potential, given the continued edging down of the unemployment rate, a recent pickup in productivity growth, and problems with measures of spare capacity.

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Unemployment Rate

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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Average Hours per Week

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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8. Perhaps the greatest near-term risk to the outlook was the possibility of a sharper-than-expected drop in house prices, though the extent of the risk was debatable. BOE officials argued that the sensitivity of consumption to house prices had declined in recent years: despite the sharp increase in house prices since 2002, real household consumption growth had remained stable, as increasing mortgage debt had been largely offset by home improvement and financial asset accumulation. Staff responded that, even though the correlation between changes in house prices and changes in consumption may have weakened since 2002, the ratio of consumption to disposable income had risen over the past decade alongside increasing housing wealth. Moreover, the effect of a drop in house prices could be asymmetric if it led banks to tighten lending criteria, constraining some households from borrowing to smooth consumption.

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House Prices and Household Consumption Growth

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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Household Debt and Financial Assets

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

1/ Excluding assets held by life insurance and pension funds.

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9. Staff asked whether the weakness of exports raised concerns about competitiveness. Officials said that industrial countries generally had been losing export share, probably reflecting the increasing integration of emerging market countries in the global economy; relative to G7 countries, the United Kingdom’s export share had remained stable. The increase in the trade deficit in 2004 was partly due to cyclical factors, and the level remained below historical highs. In addition, the United Kingdom’s international investment position was only slightly negative—net liabilities were about 5–10 percent of GDP. Although the real effective exchange rate had appreciated slightly over the past 12 months, it remained in the range of the past several years. Staff argued that a further widening of the trade deficit would be a concern, but agreed with officials that—consistent with the latest CGER assessment—there was not strong evidence of major overvaluation.

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U.K. Export Share

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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10. Higher oil prices were also not a major concern. The United Kingdom is a small net oil exporter, and the oil intensity of output is the lowest among G7 countries. Officials and staff agreed that higher oil prices could dampen economic activity in the short term, but less so than in other G7 countries. Also, higher oil prices would likely have only a small direct impact on inflation, as energy accounts for only about 5 percent of the CPI basket. Firmly-entrenched inflation expectations and the flexible labor market would likely limit second-round effects.

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Oil Intensity

(Kgs per $ of PPP GDP, 2003)

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

1/ Average of France, Germany and Italy.

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11. Officials saw global imbalances as a risk to the outlook. Officials and staff agreed that a disorderly resolution of global imbalances could result in slower global growth, which would hurt U.K. growth. Regarding the possibility of further U.S. dollar depreciation, BOE officials did not see a reason to expect a divergence from recent developments, in which sterling appreciation against the U.S. dollar had been largely offset by depreciation against the euro, implying little change to the effective exchange rate.

B. Monetary Policy

12. BOE officials felt that monetary policy had been appropriate over the past several years. They noted that between 1997 and end-2003 (when the inflation target variable was changed from RPIX to CPI), average RPIX inflation had been almost identical to the 2½ percent target.² Low goods price inflation—reflecting falling import prices as well as declining margins and accelerating productivity in the distribution sector—had been offset by high housing depreciation (reflecting booming house prices). Over the past year, the rise in interest rates had helped dampen domestic demand and house price appreciation and thereby contain incipient inflation. The change in the target variable had implied a slight effective increase in the target, as the difference in index methodologies (subtracting about ½ percent) and exclusion of house price depreciation (subtracting about ¼ percent on average) had taken more out of inflation than the ½ percentage point reduction in the target. BOE officials observed, and staff agreed, that an immediate cut in interest rates to accommodate the increase in the target would have been inappropriate; rather, monetary policy was tightened more gradually than it would have been under the old target.

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Inflation

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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13. Staff asked whether, nonetheless, the current level of interest rates might be seen as too high. Specifically, did CPI inflation at the bottom of the target range in the past year risk entrenching below-target inflation expectations? Were projections of a return of inflation to target based on truly central assumptions? And why were interest rates higher than in other higher-inflation G7 countries? On the first question, BOE officials noted that the spread between nominal and RPI-indexed bond yields was consistent with the new CPI target. On the projections, the BOE assumed that the economy would remain at potential and that unit wage costs would continue to grow modestly, but that increasing import prices would push inflation to target (Box 2). They acknowledged that, like staff, they had been wrong about the strength of import prices in the past, but pointed to current projections for import prices similar to those in the WEO. BOE officials saw the higher level of the policy interest rate in the United Kingdom as mainly reflecting cyclical differences; they noted that implied short-term interest rates 5–10 years out were lower in the United Kingdom than in the United States or the euro area. They acknowledged that recent large fiscal deficits had probably put some upward pressure on interest rates, but would be a major complicating factor only if they persisted.

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Implied RPI Inflation Over 10 Years 1/

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

1/ Differential between 10-year nominal and index-linked bond yields.2/ After December 2003, this refers to an implied target cons is tent with the new CP I target.

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Average Earnings and Unit Wage Costs

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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Box 2.

Why Has Inflation Been Low?

Staff analysis suggests that low inflation in recent years can be explained reasonably well by a combination of downward pressure from external shocks and inflation persistence.¹ Specifically, an estimated expectations-augmented Philips curve shows that declining import prices and increased competitive pressures, proxied by sterling’s real appreciation, were the main factors behind low inflation. An important degree of persistence in inflation, in turn, helped to spread the effects of the external shocks over time.

Based on this inflation equation, staff forecast that CPI inflation will rise gradually toward the 2 percent target over the next 2–3 years (see figure). The upper and lower bounds in the figure represent the projected mean squared error of the forecast. Three factors will work to push inflation higher: rising import prices, the closing of the small negative output gap, and well-anchored inflation expectations. The significant persistence in inflation is expected to slow the rise in inflation.

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CPI Inflation

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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¹Selected Issues Paper, How Should Policymakers Respond to a Decline in House Prices?

14. BOE officials said the direction of the next move in the policy interest rate would depend on changes in economic prospects. With nominal GDP growth in 2005–06 projected to be about 5 percent, the policy interest rate of 4¾ percent was now in the vicinity of the neutral rate. Given the important uncertainties to the outlook—including the degree of spare capacity and the impact of weakening house prices on consumption—the next move in interest rates could be up or down, depending on how the economy evolves relative to baseline projections.

15. BOE officials saw monetary policy as well-positioned to respond to shocks. Should house prices fall by more than currently expected, the monetary policy response would depend on the magnitude of the fall and the sensitivity of household consumption. BOE and Treasury officials concurred with the results of a staff study suggesting that monetary (and not fiscal) policy should bear the burden of the response to a house price shock, especially given the current fiscal position (Box 3). Equally, the monetary policy response to a large change in the exchange rate (as part of an unwinding of global imbalances) would depend on its inflationary impact. With the policy rate at 4¾ percent and inflation expected to rise only gradually to target, BOE officials and staff agreed that there was ample room to tighten or loosen monetary policy.

Box 3.

Policy Response to a Sharp Decline in House Prices

Staff analysis suggests that monetary policy is well-positioned to address the potential adverse macroeconomic impact of a sharp decline in house prices.¹ While staff and most observers expect house prices to decline modestly in 2005, there is a risk that house prices could decline sharply, so staff consider the impact of a range of potential declines in house prices relative to baseline in a simulation model of the United Kingdom. The analysis shows that, even if the shock is quite large (30 percent decline and consumption sensitivity in line with historical experience), large interest rate cuts could limit the negative impact on real GDP (solid line in figure). Further, even if monetary policy easing led unexpectedly to a burst in inflation, the risk of inflation rising more than 1 percentage point above target is extremely low because inflation is currently below target.

The analysis further suggests that, with inflation below target but fiscal deficits still quite large, it would be prudent to rely exclusively on monetary policy. Allowing automatic stabilizers to operate fully would of course mitigate the decline in output and increase fiscal deficits (solid line in figure). However, if fiscal policy provided a temporary stimulus, to which monetary policy responded endogenously, the impact on output would be very small, but the deterioration in the fiscal position could be considerable (dashed line in figure).

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Source: MULTIMOD.

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¹Selected Issues Paper, How Should Policymakers Respond to a Decline in House Prices?

16. On the whole satisfied with the transparency of the inflation targeting regime, the BOE has continued to experiment with improvements. Staff welcomed the increased emphasis on inflation projections using market expectations of future interest rates and the extension of the projection horizon from two to three years. To further help financial markets better understand the conduct of monetary policy, staff suggested that the BOE publish numerical projections not just for real GDP and CPI but also for other key macroeconomic variables. BOE officials noted that, as their forecast represented the collective judgment of MPC members, securing agreement on quantitative projections (and error bands) for a wider range of variables would be excessively time consuming. Staff and BOE also discussed the pros and cons of publishing an illustrative path for interest rates consistent with the inflation target. This would represent the actual process of monetary policy making, in which the inflation target was given and interest rates were adjusted to achieve it. As such, it could help guide market expectations more smoothly, a view underlying New Zealand’s successful experience with publishing interest rate forecasts. BOE officials had two objections: they noted that it would be inordinately time consuming for MPC members to agree on the path; and they feared that the announcement of an illustrative path could be disruptively misinterpreted as a BOE commitment to follow the path, rather than a view about a path conditional on the information available at a given time.

C. Fiscal Policy

17. The authorities emphasized that fiscal policy was rooted in medium-term considerations. Fiscal rules introduced in 1998—a golden rule requiring the public sector’s current balance to be non-negative on average over the business cycle and a sustainable investment rule requiring net public sector debt to be kept at a stable and prudent level (which the Treasury regards as below 40 percent of GDP)—were part of a framework assuring fiscal solvency and scope for automatic stabilizers to respond to fluctuations in demand. Discretion focused on decisions about the role of the government in the economy and taxation required to meet that role. In this context, the government had initiated in 2000 a multi-year increase in spending on health, education, transportation, and law and order. This coincided with a drop in revenues relative to GDP as the equity price boom unwound. Thus, the current balance had shifted over the current cycle—which in the Treasury’s view began as GDP crossed trend in FY1999/2000 and should end in FY2005/06—from an initial surplus of 2 percent of GDP to a deficit of 2 percent of GDP in FY2003/04. The authorities expected several developments—a tapering off of spending growth and a rebound in the revenue ratio (owing to higher corporate taxes and the closing of a still-substantial output gap)—to partially reverse this deterioration and ensure that the fiscal rules were respected. At this stage, therefore, they saw no need and had no plans for discretionary action. However, clear evidence that projected improvements in the fiscal accounts were in doubt would prompt immediate action.

Fiscal Balances and Public Debt ^{1/ 2/}

(In percent of GDP)

Sources: Budget 2004, and staff projections.

^1/Official projections based on official GDP, and staff projections based on staff’s GDP.

^2/In fiscal years, which run from April to March.

Fiscal Balances and Public Debt ^{1/ 2/}

(In percent of GDP)

	1999/00	2000/01	2001/02	2002/03	2003/04	2004/05	2005/06	…	2009/10
Overall balance	Actual					Proj.
2004 Budget	…	…	-0.1	-2.2	-3.1	-2.9	-2.7		-1.5
Staff	1.7	-0.8	0.0	-2.4	-3.2	-3.0	-3.1		-2.4
Cyclically-adjusted overall balance
2004 Budget	…	…	-0.4	-1.6	-2.2	-2.2	-2.5		-1.5
Staff	1.5	-1.3	-0.6	-2.3	-2.7	-2.8	-3.1		-2.4
Current balance
2004 Budget	…	…	0.9	-1.2	-1.9	-1.1	-0.6		0.8
Staff	2.0	2.1	0.9	-1.3	-1.9	-1.1	-1.0		-0.1
Cyclically-adjusted current balance
2004 Budget	…	…	0.6	-0.6	-1.0	-0.4	-0.4		0.8
Staff	1.9	1.5	0.4	-1.2	-1.4	-0.9	-1.0		-0.1
Output gap
2004 Budget	…	…	0.0	-1.2	-1.4	-0.8	-0.1		0.0
Staff	0.1	1.1	0.5	-0.5	-0.7	-0.1	0.0		0.1
Net public debt
2004 Budget	…	…	31.0	32.3	33.7	35.3	36.4		38.0
Staff	37.2	32.0	31.0	32.3	33.7	35.4	37.1		41.4

Sources: Budget 2004, and staff projections.

^1/Official projections based on official GDP, and staff projections based on staff’s GDP.

^2/In fiscal years, which run from April to March.

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Fiscal Balances and Public Debt ^{1/ 2/}

(In percent of GDP)

	1999/00	2000/01	2001/02	2002/03	2003/04	2004/05	2005/06	…	2009/10
Overall balance	Actual					Proj.
2004 Budget	…	…	-0.1	-2.2	-3.1	-2.9	-2.7		-1.5
Staff	1.7	-0.8	0.0	-2.4	-3.2	-3.0	-3.1		-2.4
Cyclically-adjusted overall balance
2004 Budget	…	…	-0.4	-1.6	-2.2	-2.2	-2.5		-1.5
Staff	1.5	-1.3	-0.6	-2.3	-2.7	-2.8	-3.1		-2.4
Current balance
2004 Budget	…	…	0.9	-1.2	-1.9	-1.1	-0.6		0.8
Staff	2.0	2.1	0.9	-1.3	-1.9	-1.1	-1.0		-0.1
Cyclically-adjusted current balance
2004 Budget	…	…	0.6	-0.6	-1.0	-0.4	-0.4		0.8
Staff	1.9	1.5	0.4	-1.2	-1.4	-0.9	-1.0		-0.1
Output gap
2004 Budget	…	…	0.0	-1.2	-1.4	-0.8	-0.1		0.0
Staff	0.1	1.1	0.5	-0.5	-0.7	-0.1	0.0		0.1
Net public debt
2004 Budget	…	…	31.0	32.3	33.7	35.3	36.4		38.0
Staff	37.2	32.0	31.0	32.3	33.7	35.4	37.1		41.4

Sources: Budget 2004, and staff projections.

^1/Official projections based on official GDP, and staff projections based on staff’s GDP.

^2/In fiscal years, which run from April to March.

18. Staff saw considerably greater risks from unchanged policies. The cumulative current balance in this cycle is still in small surplus, so the golden rule is likely to be met or missed by an insignificant amount. Net public debt is projected to be well below 40 percent of GDP in FY 2004/05. Staff, however, argued that the next cycle—regardless of when it begins—would start with a sizable current deficit, in contrast to the present cycle’s initial surplus. Staff accepted that spending growth would taper off as planned and that the revenue-to-GDP ratio would rise over the medium term owing to fiscal drag (about 0.1 percent per year) and anti-fraud measures. But staff were less sanguine about the level of potential GDP (and therefore the strength of structural revenues) and the buoyancy of financial sector taxes over the medium term. As a result, without discretionary measures, staff projected an improvement in the overall balance relative to GDP between FY2004/05 and FY2009/10 of ½ percentage point, compared to the Treasury’s 1½ percentage point. On staff’s projection, the golden rule would not be met in the next cycle and the sustainable investment (debt) rule would be broken eventually.³

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Output Gap

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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Cumulative Current Balance

(since FY1999/00)

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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19. In this context, Treasury and staff views diverged on the appropriateness of the fiscal stance in FY2004/05. Notwithstanding higher-than-budgeted current spending and lower-than-budgeted revenue in the first nine months of the fiscal year, staff’s projections assume that spending will be in line with the budget and that revenue will rebound due to the acceleration in corporate income and personal bonuses and windfall oil receipts (close to ¼ percent of GDP). Although the cyclically-adjusted current balance relative to GDP is expected to improve by ½ percentage point, the increase in investment implies a roughly unchanged overall balance and a small overall fiscal stimulus. Staff observed that the strengthening economy provided an opportunity for securing an adjustment in the overall fiscal balance, as had been recommended last year. In the authorities’ view, however, the critical adjustment was in the current balance where the improvement was indeed substantial.

20. Treasury officials and staff also differed on whether the overall deficit would narrow in FY2005/06 as projected in the December 2004 Pre-Budget Report (PBR). Treasury officials explained that these projections were based on the standard assumptions of no further tax changes and spending within the medium term plan updated in the July 2004 biennial Spending Review. On the assumption that growth would be faster than trend and tax buoyancy would improve, revenues would rise relative to GDP by more than spending: the current deficit was projected to fall to about ½ percent of GDP. Staff took the position that the underpinnings of the projected revenue increase—a sharp increase in corporate revenues alongside a sizable pick-up in income growth during 2005—were overly optimistic.

21. Given these misgivings, staff argued for near-term adjustment measures. Immediate action would allow smoother adjustment, lower the risk of an eventual procyclical adjustment, protect against any slippage in the credibility of the fiscal rules, and help build a buffer for future shocks. Ideally, in staff’s view, adjustment would focus on containing the growth of current spending. Existing plans already incorporate slower current expenditure growth over the coming three fiscal years than in the previous three years, but current spending is still projected to rise by about ½ percentage point of GDP by FY2007/08. Staff noted that an earlier slowing would help guard against risks of inefficiency, inherent in recent rapid increases in spending.

22. Treasury officials noted that the program to increase spending on public services would need to be seen through to completion. They argued that the framework to monitor and improve the delivery of public services had already achieved considerable success. Staff, however, observed that progress had not been uniform (Box 4). Treasury officials emphasized that a new framework to monitor the efficiency of spending was being established and that detailed plans for achieving 1½ percent of GDP of savings by FY2007/08 already existed. Staff acknowledged the scope for efficiency gains, including through improved procurement practices and relocating parts of the civil service to lower-cost areas, but argued that the continued rapid growth of spending would make achieving these gains more difficult. Also, because the government’s plan is to plough back any efficiency gains into spending, such gains would not help reduce the fiscal deficit.

23. Staff emphasized that adjustment from revenue increases would need to avoid increasing disincentives to work or other distortions. Wider application of user fees on public services would be an efficiency enhancing option. Treasury officials noted that they were studying the feasibility of national road use fees, but reported no plans to further expand user fees in education or extend user fees to health services. On other revenue adjustments, staff argued that the emphasis should be on broadening the tax base, for example by eliminating VAT zero-rating, rather than raising tax rates. Treasury officials responded that the government’s 2001 election manifesto explicitly ruled out raising VAT rates. Staff argued against raising labor taxes, such as income taxes or National Insurance Contribution rates, because of the adverse effects on labor supply. Staff noted that the planned integration of Inland Revenue and Customs will improve tax collection, but is not expected to have a significant impact on revenue.

24. Staff discussed ways to further enhance the transparency and credibility of the fiscal projections. Regarding transparency, staff noted that, given the asymmetry of the golden rule (current balance or better over the cycle) and the inevitability of economic shocks, ensuring that the rule would be met in any circumstances would be costly in terms of requiring a sizable average current surplus target (Box 5). Therefore, staff recommended that the Treasury be explicit about the probability of meeting the rule and about the implied target for the average current surplus over the cycle. Fiscal projections based on central (not “cautious”) assumptions and uncertainty around them should be shown in fan charts. Treasury officials responded that the visible buffer created by using central assumptions could produce additional spending pressures. Regarding credibility, staff noted that the National Audit Office—which is independent of the government and reports directly to Parliament—currently audits eleven assumptions used in the revenue projections, but recommended that the reach of independent assessment of assumptions underlying the fiscal projections, including the timing of the economic cycle, be broadened. Treasury officials felt that the fiscal projections already received extensive and adequate outside scrutiny, including from research institutes that provide testimony to Parliament.

Box 5.

The Golden Rule—How Much Safety Margin Does It Need?

Given that the golden rule is asymmetric (current balance or better over the cycle) and that shocks are inevitable, the government would need to target a large current surplus if it wanted the probability of meeting the rule to be large. Using a reduced-form stochastic model of the current balance based on the output and asset price shocks experienced by the U.K. economy over the past four decades, staff analysis explores the relationship between the probability of meeting the golden rule and the targeted average current surplus.¹ The analysis incorporates exogenous shocks to discretionary fiscal policy but assumes no endogenous discretionary fiscal policy response to economic shocks over the cycle.

The results show that increasing the desired probability of meeting the rule has a large impact on the implied target for the average current surplus (see table). The safety margin needed to meet the golden rule with a 75 percent chance is ½ percent of GDP; increasing this probability to 99 percent requires a safety margin of 2¼ percent of GDP. In other words, attempting to drive the risk of breaching the rule to close to zero is very costly from macroeconomic and intergenerational perspectives. Thus, it is important to be explicit about both the desired probability of meeting the rule and the associated target for the average current surplus.

Sources of Uncertainty and the Safety Margin

^1/The overall safety margin is smaller than the sum of the individual safety margins because different shocks partly offset each other.

Sources of Uncertainty and the Safety Margin

Probability of Meeting the Golden Rule	75 percent	95 percent	99 percent
Overall safety margin 1/	0.60	1.50	2.30
Output uncertainty only	0.45	1.06	1.71
Asset price uncertainty only	0.30	0.90	1.44
Discretionary policy uncertainty only	0.17	0.44	0.63

^1/The overall safety margin is smaller than the sum of the individual safety margins because different shocks partly offset each other.

View Table

Sources of Uncertainty and the Safety Margin

Probability of Meeting the Golden Rule	75 percent	95 percent	99 percent
Overall safety margin 1/	0.60	1.50	2.30
Output uncertainty only	0.45	1.06	1.71
Asset price uncertainty only	0.30	0.90	1.44
Discretionary policy uncertainty only	0.17	0.44	0.63

^1/The overall safety margin is smaller than the sum of the individual safety margins because different shocks partly offset each other.

¹Selected Issues Paper, The Implementation of the Golden Rule Over the Cycle.

D. Structural Issues

25. The mission found that the challenges of population aging, though less severe than in most other industrial countries, had moved to the forefront of public debate. Just prior to the mission, a government-appointed independent Pensions Commission, charged with studying the adequacy of the pension system and private saving to meet retirement needs over the long term, had published its interim report. Laying out the key issues and likely scenarios, the study concludes that, based on a variety of assumptions (including about desired replacement ratios), some 9½ million people (almost half of the working age population over 35) have inadequate saving to meet their likely expectations about retirement incomes. The saving gap reflects several factors: the difficulty that most people face in making rational decisions about long-term saving; the complexity of the existing pension system; the high cost of selling and administering private pension products; and the lack of trust in the retail financial industry following a series of mis-selling scandals. The Commission has opened a year-long public debate and will make concrete proposals in late 2005.

26. Staff probed the robustness of the conclusions on the saving gap. A member of the Commission explained that even though the central projection had enormous error bands—reflecting uncertainties about issues ranging from demographics, to life-cycle spending patterns, to activity rates of old people, and to rates of return on investment—he was confident that a substantial saving gap existed. He added that the key issue was the middle class, as the poor were covered by means tested supplements to standard state pension benefits, and the rich generally save enough. Asked about the exclusion of housing from the calculation of the saving gap, the Commission member explained that, with sharply higher house prices, people can only afford to buy houses later in life, future house values are highly uncertain particularly insofar as they may be affected by demographics themselves, and pension gaps are not necessarily matched by housing assets across individuals. Treasury officials welcomed the Report and the public debate it has generated. They noted that its conclusions were similar to those of the 2002 Green Paper on Pensions, which had found that 3 million people were seriously undersaving and an additional 5–10 million would have to save more or work longer. Staff agreed that there was strong evidence that many people were not saving enough to meet their likely expectations of retirement income.

27. Views on the solution to the saving gap covered a wide spectrum. Most interlocutors, except the trade unions, agreed that an increase in the pensionable age (in addition to the extension to 65 years currently scheduled to be phased in for women between 2010 and 2020) and greater flexibility for people to trade off working longer for higher pensions would be essential parts. Staff also supported the development of deeper markets for long-term, fixed-income and longevity-linked financial instruments. Beyond that, however, views differed widely on the appropriate role of government in promoting private saving. Treasury officials tended toward the view that results of existing measures to encourage private saving, including the effort to improve the financial education of households (which is at the forefront of international practice), simplification of the taxation of pensions, the creation of a Pension Protection Fund to protect occupational pension schemes, and the reform of stakeholder products (simple pension-saving vehicles for individuals), needed to be assessed before new schemes were introduced. The Commission member, however, cautioned that it would take too long to see whether encouragement is enough to ensure adequate saving. One view was that a more proactive approach would be needed to strike the right balance between the risk of having too many disappointed pensioners and the risk of motivating or forcing people to save more than they need. The debate, he expected, would come down to expanding the state pension system (currently the U.K. system is one of the least generous among industrial countries), increasing compulsion beyond that which already exists, or strengthening voluntary saving (for example by introducing automatic enrolment, using the tax system to reduce collection costs, or having the government negotiate on behalf of savers to lower mutual fund fees).

28. Officials and staff welcomed the narrowing of the gap between productivity in the United Kingdom and the average in other G7 countries, but were unsure how much further this would go. Officials attributed the more rapid productivity growth in the United Kingdom since the early 1990s to structural reforms and macroeconomic stability. They had difficulty, however, identifying the precise reasons for the remaining productivity shortfall of about 10 percent. Consequently, they had adopted a multi-pronged approach to eliminating it. As previous staff work had found that this gap is due to a variety of factors, staff concurred. Beyond this broad approach, officials were systematically monitoring and evaluating the government’s various initiatives, modifying (such as the small-firm loan guarantee program) or eliminating (such as the zero corporate income tax rate for small firms) them as indicated. Officials were also considering how to streamline business regulation, as surveys show that firms are concerned about regulatory burden (even though work by the OECD suggests that regulation in the United Kingdom is light compared with other industrial countries).

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Productivity Growth per Hour Worked

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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Productivity per Hour (level)

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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29. Staff asked about efforts to help the large number of incapacity benefit (IB) recipients move into work. Officials noted that, following reforms in 1995 to eliminate the earnings-related component of the benefit and tighten qualifying conditions, the flows into IB had slowed. In recent years, the focus has been on using active labor market policies to help IB recipients move into work. Over the past year, a pilot program (“Pathways to Work”) introduced a range of interventions at job centers, such as work-focused interviews for IB recipients. Staff welcomed the apparent early success of this program and its planned extension to about one-third of the country.

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Incapacity Benefits: Claimants

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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30. Another ongoing structural concern—rigidities on both the demand and supply side of the housing market—had been the subject of two government-sponsored reports in the past year. The Barker Report, addressing supply side problems, had recommended increasing the price sensitivity of housing supply and reducing delays in the planning process. Treasury officials said that the government had accepted the Report’s recommendations and was working on reforming complicated housing market regulations. Public consultation was planned for mid-2005. On the demand side, the Miles Report had suggested promoting long-term, fixed-rate mortgages by increasing the transparency of mortgage pricing and improving funding options for lenders. With the FSA having taken on mortgage regulation in 2004, some changes to improve information available to households on mortgages had already been made. The FSA will consider other Miles recommendations in its forthcoming review of mortgage regulation. Potential funding barriers were also being addressed: legislation now before Parliament would remove a constraint on the future ability of building societies to own securitized assets, and the government planned to review minimum funding limits for building societies.

31. Some observers have speculated that the structure of property taxation has contributed to house price volatility. With the long interval between property assessments for the Council Tax, effective property tax rates have fallen by the largest amounts for houses whose prices have risen the most. Staff empirical work on the effect of lower user costs on house price appreciation, however, showed that the tax impact was small (Box 6). Also, staff noted that attempts to mitigate this effect (for example through more frequent assessments of property values) would contribute to unwelcome volatility in local tax revenues. Officials said that a review, currently underway, of the entire structure of local government finance would examine these issues.

Box 6.

Property Taxation—Need for Reform?

Residential property is subject to the Council Tax, a local tax introduced in 1993 that is based on property assessments in 1991. The effective Council Tax rate (tax divided by current market value) has therefore declined as house prices have increased and is now much lower in parts of the country (such as London) where house prices have risen the most. Thus, the current structure of property taxation has in principle contributed to the run-up in house prices by reducing the user cost of housing as house prices have risen. However, empirical work by staff suggests that this effect is small.¹

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Effective Council Tax Rate in England

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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The government has asked Sir Michael Lyons to review local government finance and make recommendations by the end of 2005. In parallel, a reassessment of property values is planned for 2005, to come into effect in 2007. In this context, the Lyons review will make recommendations on how best to reform the Council Tax, taking into account the forthcoming property revaluation.

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Regional implicit Council Tax rates in 2003

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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¹Selected Issues Paper, Property Taxes and the Housing Market.

E. Financial Sector Stability

32. The authorities observed that virtually all indicators suggested that the banking system remained sound and risks were low. Profitability, capitalization, and credit quality were strong: the median return on large banks’ equity rose from 24 percent in 2003 to 27 percent in the first half of 2004; total and tier-I capital ratios remained well above regulatory minima; and mortgage arrears and corporate insolvencies continued to fall. Although weakening house prices would likely reduce credit growth and thus dampen bank profitability, officials and private analysts said that mortgage lending did not constitute an important risk to financial stability: not only were household debt service ratios low, but also average loan-to-value ratios had declined to 40–50 percent. However, the rapid growth of unsecured debt (especially credit card debt) was a concern, especially because borrowing rates were high and debt was not evenly spread across households. Another potential vulnerability was corporate lending related to commercial property, especially given its recent rapid growth and signs of a deteriorating office market. A third important vulnerability was that the search for yield posed challenges for risk management, not least because it may have led some financial institutions to build up positions in what could prove to be relatively illiquid assets.

Bank Credit Exposures

(in percent of bank capital)

Source: Bank of England.

Bank Credit Exposures

(in percent of bank capital)

Lending to:	end-2004
Households	319
Secured	265
Unsecured	54
of which: Credit card	18
Private nonfinancial corporations	101
of which: Real-estate related	55

Source: Bank of England.

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Bank Credit Exposures

(in percent of bank capital)

Lending to:	end-2004
Households	319
Secured	265
Unsecured	54
of which: Credit card	18
Private nonfinancial corporations	101
of which: Real-estate related	55

Source: Bank of England.

33. The BOE is planning to introduce a voluntary reserve system as part of a wider reform of the sterling money markets, the core objectives of which are to reduce volatility in overnight money markets and improve banks’ liquidity management. The reform may also encourage more banks to join the real time gross settlement system, which would lower intraday credit exposures between banks in the payments system, consistent with FSAP recommendations. In response to staff’s question about the reaction of financial market participants, BOE officials said that early feedback suggested that the proposal was welcome and that participation in the system would be more than sufficient to achieve the BOE’s objectives. BOE officials added that they would publish in early 2005 a new Payments Systems Oversight Report, in line with FSAP recommendations.

34. The authorities highlighted improvement in the health of the insurance sector over the past year. Among life insurers, solvency margins had increased as equity prices rose. Among nonlife insurers, profitability had increased, reflecting improving claims experience, firm premium rates, and better investment returns. Officials and private analysts added that risk management was improving, owing in part to the introduction in 2004 of a new risk-based capital adequacy regime that went beyond the EU Solvency I framework. The FSA was to start to regulate brokers in 2005 and expected that improvements in risk management, which had lagged, would accelerate.

35. The authorities noted that the AML/CFT regime had been strengthened in line with FSAP recommendations. Officials observed that the regime’s coverage was extensive, given that it included, beyond the financial sector, lawyers and accountants and that all suspicious transactions must be reported. The authorities were stepping up their oversight to ensure compliance with the legal and regulatory requirements, and are keeping the regime under review in order to make it more effective. This was illustrated in a recent report, which showed that the authorities’ efforts to sensitize senior financial sector managers to money laundering were producing results. Officials also noted that they had implemented the EU second AML directive and were reviewing regulations to ensure full compliance with the updated FATF recommendations.

F. Other Issues

36. Regarding euro adoption, the authorities said that the government remained in principle in favor of joining the single currency. In practice, the economic conditions needed to be right. Staff concurred, noting that the float was now satisfactory and that—given the irreversibility of euro entry—the authorities needed to feel confident that the case for entry had been established with a sufficient degree of certainty. The authorities said that progress on the reform agenda set out in the 2003 assessment of the five tests for euro adoption had been reviewed in the 2004 Budget and would be reviewed again in the forthcoming Budget. The authorities hoped that convergence would occur in both directions, for example the German mortgage market would be liberalized as long-term, fixed-rate mortgages were promoted in the United Kingdom. Staff asked about the authorities’ view on the growing empirical evidence of the favorable effect of euro adoption on cross-border trade. The authorities noted the large range of estimates and inter-country differences. Staff agreed and said that further research was needed to pinpoint the reasons for the differences.

37. Staff praised the government’s consistent support for trade liberalization within the European Union. Officials welcomed the July 2004 framework agreements for the Doha Round, especially their detail on domestic support and export subsidies, and regretted that the agricultural market access pillar is the least detailed. Officials advocated elimination of trade-distorting effects of the Common Agricultural Policy and said that the EU can and should push ahead with agricultural reform so that border protection is substantially reduced, export subsidies are no longer an issue for world trade by 2010, and all agricultural tariff peaks are reduced towards the maximum level for non-agricultural products. The United Kingdom has consistently supported in the WTO and the EU the liberalization of services trade and sees itself benefiting from a less restrictive environment.

38. Staff welcomed the increase in the U.K. ODA. Even before recent commitments in response to the tsunami, officials said that the 2004 Spending Review foresaw a further increase in ODA to 0.47 percent of GNI by FY2007/08, with the goal of reaching the United Nations target of 0.7 percent of GNI by 2013. Officials said that, with the United Kingdom’s leadership of the G7 in 2005, the government would press for increasing aid flows, by implementing the International Finance Facility and extending debt relief.

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UK ODA

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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G7 ODA, 2003

Citation: IMF Staff Country Reports 2005, 080; 10.5089/9781451814279.002.A001

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