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The key risk is that persistent slow growth could permanently damage medium-term growth prospects—this could arise if private sector deleveraging is larger than expected, credit conditions fail to improve, external demand does not pick up, and the drag from fiscal consolidation is greater than anticipated. In addition, despite recent market calm, growth in the euro area is likely to be weak, and the re-emergence of market tensions cannot be ruled out, with the potential for continued spillovers to the UK from depressed exports, higher bank losses and funding costs, and reduced confidence.
Financial sector repair has advanced, but banks are still not restored to healthy functionality. On the positive side, funding is more assured and regulatory capital ratios continue to edge up. However, the share of non-performing assets across some major banks remains at elevated levels, and underlying profitability is weak. Moreover, there are concerns pertaining to lender forbearance, under-provisioning for risky assets and conduct costs, and aggressive use of risk-weights.
A clear strategy is needed for the two government-intervened banks, with a view to returning them to private ownership. Together, RBS and LBG account for two-fifths of the stock of UK net private sector lending. The banks have made progress in repairing their balance sheets and improving profitability. But challenges remain, as evident by the recent failure to divest surplus business lines, and the still-low market-to-book value for RBS. The approaching completion of the banks’ original EC-approved restructuring plans provides an opportunity to elaborate a clear way forward. Any strategy should seek to return the banks to private hands in a way that maximises the value for taxpayers, strengthens confidence and competition in the sector, and minimises outward spillovers. In this context, if a sovereign backstop is required to meet a capital shortfall, it should be provided, as this would have a high multiplier.
While adhering to the medium-term framework, the government has shown welcome flexibility in its fiscal programme. The government has accommodated a slowdown in the pace of structural consolidation, notably in the context of weakening potential growth; allowed automatic stabilisers to operate freely; and public sector net debt is forecast to fall in 2017-18, two years later than set out in the Supplementary Debt Target. Furthermore, several measures to support growth have been introduced, such as increases in personal tax allowances and reductions to corporate tax rates. The government has also used its balance sheet to provide support through the use of guarantees. But planned fiscal tightening will be a drag on growth. Discretionary measures for this fiscal year amount to £10 billion. These will pose headwinds to growth, as expected, coming on top of domestic deleveraging and a weak external outlook, notably at a time when resources in the economy are underutilised.
Within the context of the medium-term fiscal framework, several growth-enhancing initiatives could be considered now to offset the drag from consolidation and bolster the recovery.
IMF-Article IV opening remarks by the Chancellor of the Exchequer, Rt Hon George Osborne MP © Crown copyright