By Daniel Hunter

Economic recovery in the UK continues to be slow and fragile, as domestic deleveraging pressures remain and external demand is weak, this is according to an executive report from the International Monetary Fund (IMF).

Economic activity is projected to recover going forward, but the pace of expansion is expected to be weak relative to the scale of underutilized resources. As a result, the output gap is projected to remain sizeable for an extended period, portending the risk that continued cyclical weakness will lead to a permanent loss in the economy's productive capacity.

Inflation has remained stubbornly above the two percent target, owing largely to increases in administered and policy-driven prices. Underlying inflation is, however, modest. Against the backdrop of a large output gap, inflation is expected to decline to the 2-percent target over the medium term. Risks to this central scenario remain to the downside, including from a reemergence of financial stress in the euro area and larger-than-expected headwinds from public and private sector deleveraging.

Current polices aim to rebalance the economy and strengthen financial stability. Significant progress has been made toward reducing fiscal risks, notably through front-loaded consolidation. In light of weak recovery, however, the pace of structural fiscal consolidation slowed in FY 2012/13 (April-March), while flexibility in the fiscal program allowed automatic stabilizers to operate fully. Current fiscal plans envisage additional discretionary fiscal tightening of £10 billion in FY 2013/14, and will result in an acceleration of the pace of structural consolidation.

Monetary policy in the UK has been highly accommodative to help bolster the recovery. In addition to cutting the policy rate aggressively, the Bank of England has engaged in Quantitative Easing, amounting to a cumulative £375 billion (about a ¼ of gross domestic product), and, jointly with the Her Majesty's Treasury, launched the Funding for Lending Scheme, aimed at lowering bank funding costs. The transmission of accommodative monetary policy to credit has, however, only been partially successful. Mortgage rates have declined sharply and corporate bond and equity markets have recovered strongly. But bank lending, notably to sectors of the economy unable to post high-quality collateral, such as small and medium size enterprises (SMEs), remains very weak, as bank balance sheets remain impaired.

To advance financial sector repair, the authorities have recently conducted an Asset Quality Review and laid out plans to strengthen banks' capital position. The financial regulatory structure has also being revamped, with the establishment of three new bodies–the Prudential Regulation Authority, Financial Conduct Authority, and Financial Policy Committee–aimed at bolstering financial stability.

Executive Directors noted that, despite recent signs of increasing momentum, growth prospects remain weak as the economy moves to rebalance away from public to private demand, and from domestic to external demand. Directors underscored that restoring growth and rebalancing the economy are vital to improving incomes, ensuring debt sustainability, and returning the banking sector to good health, and supported a multi-pronged policy strategy to achieve these objectives.

Directors welcomed the accommodative stance of monetary policy. Many Directors agreed that monetary policy should remain accommodative and further efforts should be made to ease credit conditions. Many other Directors were skeptical about the effectiveness of additional policy easing and called for a careful analysis of costs and benefits of further measures. Directors welcomed the extension of the Funding for Lending Scheme and its recent modifications to strengthen incentives for banks and non-banks to lend to small and medium enterprises.

Directors commended the authorities' commitment to medium-term fiscal consolidation and welcomed progress in reducing fiscal risks and ensuring the sustainability of public debt. Most Directors underscored the importance of keeping fiscal consolidation on track to preserve credibility, not least in light of the persistent weakness of the fiscal position. However, a number of other Directors noted that slow growth could undermine the credibility of the adjustment effort and called for additional flexibility within the context of the medium-term fiscal framework, including by bringing forward capital investment.

Noting that the effectiveness of monetary policy is undermined by persisting weaknesses in the banking system, Directors welcomed the steps taken to enhance the resilience of the financial system and encouraged the authorities to proceed rapidly on financial sector repair. In particular, they emphasized the need for banks to meet identified capital shortfalls without delay. Going forward, Directors noted that it would be important that the planned system-wide bank stress tests cover a broad range of risks, employ stringent scenarios, and include supervisor approved capital plans. Directors called for a clear strategy for the two state-intervened banks, including returning them to private ownership.

Directors welcomed recent progress in improving the regulatory and supervisory framework. They stressed the importance of ensuring the operational independence of regulatory and supervisory authorities and of greater coordination among these bodies. Directors emphasized that adequate resources and appropriate tools should be provided to support an intensive supervision of globally-systemic financial institutions.

Directors underscored the need for structural banking reforms to proceed apace. They welcomed the authorities' intention to reduce systemic risk by introducing ring-fencing, but noted that its effectiveness would depend on global cooperation on cross-border supervisory and bank resolution frameworks. Directors agreed that the supervision of financial institutions outside the ring-fence should also be strengthened to prevent regulatory arbitrage and the potential migration of risks to these entities.

Directors underscored the importance of further efforts on structural reforms to help the economy move toward a more dynamic and robust structure. They agreed that measures to improve the economy's skills base and competitiveness would enhance the economy's productive capacity while supporting demand in the near term.

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