BRITAIN'S PRIMARY DETERMINANT
IMF- United Kingdom: Staff Concluding Statement of the 2017 Article IV Mission
Macroeconomic Outlook and Risks
Growth in the first three quarters of 2017 was slower than a year ago. Despite a strong recovery in global growth and supportive macroeconomic policies, the impact of the decision to exit the European Union has weighed on private domestic demand. The employment rate has remained around record highs, but the sharp depreciation of sterling following the referendum pushed up consumer price inflation, squeezing household real income and consumption. Business investment growth has been lower than would be expected in the context of strong global growth and high levels of capacity utilization, owing to heightened uncertainty about economic prospects. The softening of domestic demand was partially offset by a rise in goods exports, supported by strong growth in trading partners and weaker sterling. Overall, output is expected to grow by 1.6 percent this year, broadly in line with our estimate of the economy's potential.
Growth is projected to remain around 1½ percent next year. Inflation is expected to fall gradually but stay above target, implying further pressure on real wages and private consumption. Strong global growth will provide ongoing support for exports, but firms are likely to continue deferring some investment decisions until there is greater clarity on the UK's future trading relationship with the European Union (EU). These projections assume continued progress in Brexit negotiations, culminating in understandings on a broad free trade agreement and on the transition process.
There are a number of risks around the baseline projection. Developments with Brexit negotiations are a key uncertainty. Faster-than-expected progress towards a mutually beneficial economic outcome could buoy confidence. On the other hand, a breakdown in discussions could lead to a disorderly exit from the EU and sharp falls in asset prices. Compressed risk premia and a decline in liquidity in the UK corporate bond market, still-high valuations of commercial real estate and to a lesser extent housing, and a low household saving rate are additional sources of risk to the outlook. The potential impact of these risks is magnified by the need to finance the UK's large current account deficit, which makes the economy vulnerable to shifts in investor expectations.
Brexit has the potential to reshape the structure of the UK economy. The impact will depend on the nature of the final agreement, and may take many years to fully materialize. However, in the coming years agriculture, manufacturing and services will all be affected by changes in the trade framework, regulatory structure and labor market. For example, the financial sector, which represents about 7 percent of GDP but accounts for around 10 percent of tax revenues and 14 percent of exports, may be particularly affected in the absence of an agreement that allows the majority of EU-facing financial services currently provided from the UK to remain there. Manufacturing firms with complex and lengthy international supply chains, such as in the automobile industry, could also face significant challenges. These developments could also have a significant impact on productivity growth.
Productivity growth will be the primary determinant of UK living standards in the long run. Since the financial crisis, output growth has been underpinned by strong increases in employment, while productivity growth has been extremely weak. With the unemployment rate at an historic low and the rate of net immigration of workers from the EU already falling, the scope for future employment gains is more limited. Therefore, economic performance will depend increasingly on the ability of firms to raise output per worker. The challenge the UK faces in this respect is sizable: even under the baseline assumption that labor productivity growth doubles to 1 percent from the ½ percent annual average since the financial crisis, potential growth will be only about 1½ percent per year in the medium run. The shape of the new agreement with the EU will affect productivity performance through its implications for trade, investment and migration. The higher are any new barriers to the cross-border flow of services, goods and workers, the more negative the impact would be.
Recent progress in negotiations between the UK and EU is welcome. Both parties have reached agreement in principle on citizens' rights, on Northern Ireland, and on the financial settlement. While the ultimate outcome of the next phase of discussions is for the UK and EU to determine, an agreement that minimizes tariff and nontariff barriers and ensures that firms have access to the labor they need would best support growth. The list of tasks that remains to be accomplished is very long, and the timeframe to do so is ambitious. They include agreeing on a trade deal with the EU, negotiating new arrangements with around 60 countries to replace those to which the UK is currently party via its membership in the EU, bolstering human and IT resources in customs and other services, and translating many thousands of pages of EU law into UK domestic statute. The government has set aside a budgetary allocation to support Brexit preparations. Early agreement on a transition period would avoid a cliff edge exit in March 2019 and reduce the uncertainty facing firms and households.
Monetary and Fiscal Policies
The Bank of England eased monetary policy following the Brexit Referendum and acted to ensure that this further accommodation was transmitted into lower borrowing rates for consumers and businesses. Immediately following the vote, Bank Rate was cut by 25 basis points, another round of quantitative easing was initiated, and the Term Funding Scheme (TFS) was introduced. Banks indicate the TFS has played an important role in supporting lending to the private sector. Since then, inflation has risen above 3 percent, mostly reflecting exchange rate pass-through. Going forward, the tight labor market is expected to lead to higher wage growth, increasing domestic inflationary pressures. In this context, the Monetary Policy Committee (MPC) voted at its November meeting to raise Bank Rate by 25 basis points, reversing the earlier cut.
The withdrawal of monetary stimulus should continue at a gradual pace, in line with the MPC's policy guidance. With output now roughly at the economy's potential, a withdrawal of monetary stimulus—in line with market expectations—would help return inflation to the target as the impact of previous sterling depreciation fades. Given planned fiscal consolidation, the pace of this withdrawal should be gradual. However, a faster pace of interest rate increases would be warranted if inflation expectations shift up or labor costs increase more than expected. The scaling down of the Bank of England's balance sheet should await the return of Bank Rate to a level from which it could be cut materially in the event of a demand slowdown, consistent with the MPC's current plans. Transparent and timely communication will remain critical to guide market expectations in an environment of heightened uncertainty.
Continued deficit reduction is critical to rebuild fiscal buffers against future shocks. Sustained consolidation has substantially reduced the deficit since the height of the global financial crisis. Nevertheless, at 87 percent of GDP, the public debt ratio remains high by international standards. In fact, all three of the main credit rating agencies have downgraded the UK's sovereign debt rating since the referendum, pointing to rising spending pressures, an erosion of medium-term growth prospects, and risks to the financing of the current account deficit. The fiscal framework adopted by the authorities prudently aims to reduce the deficit (after accounting for the impact of the economic cycle) to below 2 percent of GDP by 2020/21, and to balance the budget by the middle of the next decade. The recent smoothing of the annual profile of deficit reduction accommodates higher public investment while continuing to make progress towards the framework's objectives. This was an appropriate response to the weaker growth outlook. Going forward, the automatic stabilizers should be allowed to operate freely in response to demand shocks.
Over the long term, population aging will put pressure on the public finances, while productivity developments and Brexit-related effects may exacerbate the challenge. The Office for Budget Responsibility (OBR) projects that annual spending on healthcare, long-term care and pensions is projected to increase by 1 percent of GDP between 2020 and 2025, and by much more thereafter. Output losses associated with Brexit, or a failure of productivity growth to recover more generally, would shrink the revenue base from which to meet these spending demands: each 1 percentage point decline in GDP is estimated to decrease net revenues by about 0.4 percent of GDP. And if Brexit leads to the movement of a meaningful share of the relatively tax revenue-rich financial sector outside the UK, available revenues could fall even faster. The losses associated with just a 1 percentage point decline in long-run output would therefore more than offset the gains from any net savings from lower contributions to the EU budget post-Brexit. Taken together, this means that the UK may in the future face difficult decisions about the desired size of its public sector, as well as the mode of delivery and financing of public services.
Under these circumstances, greater reliance on revenue measures for consolidation than in recent years may be warranted. Deficit reduction since the financial crisis has relied mostly on spending measures. While the government should continue to seek the best value for money in public spending, a more balanced approach to deficit reduction may be called for in the future. Beyond their revenue impact, tax reforms can also be justified on efficiency grounds. Scaling back preferential VAT rates for certain goods would increase tax neutrality. Better aligning the tax treatment of employees and the self-employed would improve fairness and bring the tax system in line with evolving employment practices. Financial stability could be enhanced by reducing the tax code's bias toward debt, for example by adopting a tax allowance for corporate equity. Rebalancing property taxation away from transactions and toward values would boost mobility and encourage more efficient use of the housing stock. Finally, on the spending side, removing the triple lock on pensions would help contain rising demographic spending over the long term.
The UK continues to set international standards on fiscal transparency practices. Earlier this year, the OBR released its first Fiscal Risk Report, assessing the vulnerability of public finances to a wide range of risks. The authorities have already addressed some of the identified risks, such as by improving the oversight process for contingent liabilities like government guarantees, and will respond more fully by next summer. The results of a first-of-its-kind fiscal stress test show that public finances can deteriorate quickly under a confluence of negative shocks, reinforcing the need for continued fiscal responsibility. Starting with the Autumn 2017 budget, major tax and spending decisions have been unified into a single fiscal event earlier in the financial year, as recommended in the 2016 Fiscal Transparency Report. This allows more time for Parliamentary and public scrutiny of budgets while increasing certainty for households and firms.
Financial Sector Policies
UK banks' balance sheets have strengthened steadily since the financial crisis. Capital, leverage, and liquidity positions are all well above international regulatory minima and any additional domestic requirements. The Bank of England's recently concluded stress tests indicate that the major UK banks are all sufficiently well-capitalized to withstand simultaneous UK and global recessions, large falls in asset prices, and stressed misconduct costs. To address the too-big-to-fail problem, a package of major bank resolution reforms is being implemented, including ring-fencing, total loss-absorbing capacity and resolution planning requirements.
The authorities have taken steps to address emerging pockets of risks to financial stability. Although overall bank credit is increasing broadly in line with nominal GDP growth, consumer credit has grown rapidly over the last two years, while increasing competition in the banking sector has compressed spreads on mortgage and consumer loans. Consumer credit developments need to be monitored closely to assess the effectiveness of measures taken to strengthen underwriting standards. Further action may be necessary if high rates of growth persist, including steps to enhance the oversight of nonbank financial institutions. The recent increase in the countercyclical capital buffer was appropriate given the current stage of the financial cycle. The level of the buffer should be kept under review to ensure it continues to evolve in line with the overall risk level. Adopting the Basel III finalization agreement would help reduce excess variability in risk weights across banks using internal models. Supervisors should continue scrutinizing banks' risk weights to ensure they appropriately reflect risk exposure, adjusting PRA capital buffers where necessary. Finally, the authorities should consider conducting a system-wide liquidity stress test of the major UK banks in a future biennial exploratory scenario.
Brexit presents major challenges to the financial sector and supervisors. The recently concluded stress tests suggest that the major UK banks are sufficiently well-capitalized to withstand a disorderly Brexit. However, even an orderly Brexit could imply significant changes for the sector. The UK's prudential regulators and supervisors have taken a proactive approach to help regulated firms prepare for exit from the EU. The authorities are making progress in translating EU financial regulations into UK law, and where necessary have been replicating EU institutional capacity to ensure a smooth transition. While the primary responsibility for transition preparations lies with the institutions themselves, some areas—such as ensuring the continuity of long-dated, cross border insurance and derivatives contracts, and allowing continued transfer of personal information about borrowers and depositors across borders—would be most efficiently achieved through coordinated EU and UK legislation. It would be in the interest of both sides to reach agreement on these issues early in the negotiation process to reduce uncertainty and have a sufficiently long transition period to implement necessary changes. Close cross-border regulatory and supervisory cooperation remains essential to assess risks and vulnerabilities, especially with a potentially more complex and fragmented European financial system. Regulation and oversight arrangements related to euro-denominated derivatives clearing on UK-based central counterparties, and especially permissions for EU banks, will require careful design.
Under a tail risk scenario of a disorderly Brexit, policies should be geared toward supporting macroeconomic and financial stability. In the event of an adverse market reaction, with sharp declines in a range of asset prices, the Bank of England will need to ensure that the financial system has adequate liquidity, including by maintaining swap lines with other major central banks. The implications of Brexit for monetary policy are uncertain, with the appropriate response depending on the relative shifts of supply, demand and the exchange rate. The authorities could use the flexibility contained in the fiscal framework to provide support to the economy. However, should the shock affect confidence and raise risk premia, the room to respond could narrow. Any easing of fiscal policy should therefore be temporary, limited and anchored by credible medium-term fiscal consolidation plans. A permanent shock to output would require an eventual adjustment of revenues or spending.
Higher productivity is important to increase living standards, make growth more inclusive, and help address looming fiscal challenges. Despite continuous fiscal consolidation, public infrastructure investment has increased in recent years. The budget envisages further increases in capital spending over the medium term, including through the National Productivity Investment Fund, which the government announced in 2016 and extended in 2017, which aims to improve the quality of UK infrastructure and raise productivity. The government has tasked the independent National Infrastructure Commission with taking the lead in assessing long-term infrastructure priorities, and the Commission will release its first National Infrastructure Assessment next year. Increasing human capital is also critical. The recent announcement of T-level qualifications and the introduction of the apprenticeship levy aim to raise job-specific skills and to promote higher level technical skills and reduce regional disparities in skills provision. It will be important to monitor and evaluate the effectiveness of these programs once they have been in place for some time. The government recently announced a package of spending measures and guarantees intended to boost housing supply. Continued efforts are needed, including easing planning restrictions and reforming property taxes to address chronic shortages that prevent workers from relocating to seize better opportunities.
The UK is noteworthy for the extent of its regional productivity differences. The country includes some of the highest but also some of the lowest productivity regions among the advanced economies. There is no single solution to boosting regional productivity: addressing congestion and housing restrictions is most important for more successful regions, while other regions should focus on increasing human capital and improving transport connectivity. A greater role for local decision-making has the potential to better tailor policies to economic conditions, for example by ensuring that eligibility requirements and curricula for technical training are best adapted to the needs of local students and employers.
The government has adopted further measures to enhance the transparency of companies and trusts. The 2017 Money Laundering Regulations and the Criminal Finances Act have been adopted and the second National Risk Assessment of money laundering and terrorist financing has been completed. The establishment of central registers for companies and trusts is a positive development, but mechanisms to verify ownership information should be strengthened. Improving the effectiveness of Anti-Money Laundering/Combating the Financing of Terrorism supervision of trust and company service providers (including lawyers and accountants performing such services) will also help ensure that the ownership information they collect is accurate and accessible by tax and law enforcement authorities. Continued engagement with Crown Dependencies and Overseas Territories on the exchange of information on companies and trusts is also critical.
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