COMMISSION STAFF WORKING DOCUMENT In-depth review for the UNITED KINGDOM in accordance with Article 5 of Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic imbalances Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL AND TO THE EUROGROUP Results of in-depth reviews under Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic imbalances
Date: 2013-04-10
Institutions: European Commission
Subjects: United Kingdom, competitiveness, economic growth, economic recession, economic reform, indebtedness, macroeconomics, private investment, property market, public debt, trade balance

EUROPEAN 
COMMISSION 

Brussels, 10.4.2013  
SWD(2013) 125 final 

COMMISSION STAFF WORKING DOCUMENT 

In-depth review for the UNITED KINGDOM 

in accordance with Article 5 of Regulation (EU) No 1176/2011 on the prevention and 
correction of macroeconomic imbalances 

Accompanying the document 

COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN 
PARLIAMENT AND THE COUNCIL AND TO THE EUROGROUP 

Results of in-depth reviews under Regulation (EU) No 1176/2011 on the prevention and 
correction of macroeconomic imbalances 

{COM(2013) 199 final} 
{SWD(2013) 113 final} 
{SWD(2013) 114 final} 
{SWD(2013) 115 final} 
{SWD(2013) 116 final} 
{SWD(2013) 117 final} 
{SWD(2013) 118 final} 
{SWD(2013) 119 final} 
{SWD(2013) 120 final} 
{SWD(2013) 121 final} 
{SWD(2013) 122 final} 
{SWD(2013) 123 final} 
{SWD(2013) 124 final}

EN 

   EN 

 
 
 
 
 
  
 
 
 
 
 
Contents 

EXECUTIVE SUMMARY AND CONCLUSIONS..................................................................3 

1. 

2. 

2.1. 

2.2. 

2.3. 

2.4. 

2.5. 

3. 

INTRODUCTION ........................................................................................................6 

MACROECONOMIC SITUATION AND POTENTIAL IMBALANCES ................7 

Macroeconomic scene setter.........................................................................................7 

Competitiveness and export performance ....................................................................8 

Sustainability of external positions.............................................................................12 

Government indebtedness...........................................................................................12 

Private sector indebtedness.........................................................................................14 

IN-DEPTH ANALYSIS OF SELECTED TOPICS ...................................................19 

3.1. 

External competitiveness ............................................................................................19 

3.1.1  Developments in external competitiveness ................................................................20 

3.1.2  Characteristics of the UK trading sector.....................................................................26 

3.1.3 

Structural challenges...................................................................................................32 

3.1.4  Conclusions.................................................................................................................37 

3.2. 

Private debt, deleveraging and growth .......................................................................39 

3.2.1  Corporate debt and access to finance..........................................................................39 

3.2.2  Housing policy and household debt............................................................................45 

3.2.3  What risks do private debt dynamics and servicing costs pose to stability and 

growth?  ......................................................................................................................54 

3.2.4  Conclusions ................................................................................................................59 

4. 

POLICY CHALLENGES...........................................................................................60 

REFERENCES .........................................................................................................................63 

2 

 
 
 
 
 
EXECUTIVE SUMMARY AND CONCLUSIONS  

In  May  2012,  the  Commission  concluded  that  the  UK  was  experiencing  macroeconomic 
imbalances,  in  particular  as  regards  developments  related  to  household  debt,  the  housing 
market and, to some extent, external competitiveness. In the Alert Mechanism Report (AMR) 
published  on  28  November  2012,  the  Commission  found  it  useful,  also  taking  into  account 
the identification of an imbalance in May, to examine further the persistence of imbalances or 
their  unwinding.  To  this  end  this  In-Depth  Review  (IDR)  takes  a  broad  view  of  the  UK 
economy  in  line  with  the  scope  of  the  surveillance  under  the  Macroeconomic  Imbalances 
Procedure (MIP). The main observations and findings from this analysis are: 

•  The  challenges  identified  in  the  2012  IDR,  namely  the  high  levels  of  household 
debt and the deterioration in external competitiveness, remain valid. As such, the 
2013 edition of the IDR revisits these themes, while expanding and going deeper into 
selected  aspects,  including  the  dynamics  of  private  debt,  both  household  and 
corporate.  In  the  short  term  the  macroeconomic  imbalances  that  the  UK  is 
experiencing  pose  a  more  immediate  threat  to  growth  than  to  stability,  but  if  not 
addressed  they  could  store  up  future  risks  to  macroeconomic  stability  and  to  the 
financial sector. 

•  As regards external competitiveness, the UK experienced a large drop in export 
market  shares  from  2007  to  2010.  The  trade  balance  has  been  negative  since 
1997, mainly as the result of a chronic deficit in goods trade. Nevertheless, export 
volumes have been a modest net driver of growth in the UK economy in the crisis 
period. Exports were 3.3% higher in 2011 than 2007, while total GDP remained 
below  its  pre-crisis  peak.  External  performance  in  2012  was  worse  than 
anticipated,  although  the  current  account  is  expected  to  continue  to  move 
towards  a  more  balanced  position  in  the  medium  term.  The  deterioration  in  the 
UK's  current  account  balance  in  2012  was  mainly  due  to  weaknesses  in  external 
demand  and  foreign  income,  in  particular  from  European  countries,  unfavourable 
developments in oil trade, and buoyant imports despite the economic recession. The 
effects  of  the  depreciation  of  sterling  in  2008  seem  to  have  passed  through  whilst 
providing  only  a  modest  boost  to  the  trade  balance,  and  to  make  sustained 
improvements the UK needs to confront structural challenges in the areas of transport 
infrastructure,  skills  and  access  to  finance.  The  UK  faces  the  twin  challenges  of 
sustaining  the  pre-crisis  dynamism  in  service  exports  and  boosting  the  underlying 
drivers  of  productivity  in  the  industrial  sectors  in  order  to  regain  the  external 
competitiveness  that  was  partly  eroded  in  the  pre-crisis  years.  As  regards  trade  in 
services,  the  UK  has  maintained  a  significant  surplus  for  several  decades,  which 
continues  to  sustain  the  current  account  despite  the  negative  effects  of  the  global 
financial  and  economic  crisis  on  the  financial  and  professional  services  cluster.  As 
regards  trade  in  goods,  the  balance  has  been  in  a  persistent  deficit  since  the  early 
1980s and productivity levels in the manufacturing sector have fallen behind those of 
other highly-advanced economies. 

•  Household  debt  is  currently  falling,  largely  due  to  low  levels  of  new  mortgage 
lending,  but  is  likely  to  remain  at  a  high  level.  Low  interest  rates  and 
forbearance mask risks associated with a minority of over-indebted households. 
The  level  of  household  debt,  which  is  mainly  in  the  form  of  mortgages,  decreased 
slightly  in  2011  to  96%  of  GDP.  Both  residential  construction  and  new  mortgage 

3 

 
 
 
 
 
lending  remain  low,  and  continue  to  be  affected  by  a  weak  domestic  economy, 
deleveraging  pressures  and  policy  constraints.  Despite  falling  by  17%  in  real  terms 
since 2008, UK house prices remain high relative to incomes, supported by a shortage 
of housing supply. The government has put in place a number of regulatory and fiscal 
measures  aimed  at  increasing  residential  construction,  but  it  is  not  yet  clear  how 
effective  these  will  be  in  boosting  the  supply  of  housing.  Total  mortgage  servicing 
costs have been reduced by low interest rates and a high share of variable-rate debt. 
However, this hides a significant minority of very highly indebted households. As a 
consequence of a combination of high house prices and the widespread and growing 
use  of  variable-rate  mortgages,  households  are  particularly  exposed  to  interest  rate 
changes, as well as to rises in unemployment. A sharp fall in house prices remains a 
possibility,  but  household  debt  is  likely  to  pick  up  again  in  the  medium  term,  as 
housing  transactions  return  to  more  normal  levels,  unless  real  progress  is  made  in 
addressing  housing  supply  shortages.  The  private  rental  market  has  grown  in  recent 
years as more households have been priced out of home ownership, but renting is still 
not seen by most tenants as a desirable long term option. 

•  The  stock  of  UK  corporate  debt  is  moderately  high  and  there  are  signs  of  less-
than-viable  companies  being  kept  in  business  through  low  interest  rates  and 
bank  forbearance,  while  other  firms  are  having  difficulty  accessing  adequate 
funding  for  investment.  Many  corporations  have  accumulated  significant  surpluses 
in recent years and have  built strong balance  sheets, but  there  is  a  divergent  picture 
across  sectors  and  firms.  Evidence  suggests  that  a  number  of  companies  continue 
operating  despite  having  little  prospect  of  paying  off  their  stock  of  debt.  This  can 
store up risks to financial stability and prevent credit from being reallocated to more 
dynamic  and  productive  sectors  of  the  economy.  A  fine  balance  has  to  be  struck  in 
order  to  reconcile  the  longer  term  benefits  of  "creative  destruction",  and  the  shorter 
term advantages of low insolvency rates supporting employment in a weak domestic 
economy.  Firms  in  sectors  such  as  construction  and  real  estate,  and  many  SMEs, 
suffer from debt overhang or are experiencing difficulty in obtaining credit to finance 
investment.  Overall  public  investment  remains  low  and  it  is  not  clear  when  and  to 
what  extent  private  investment  will  pick-up.  On  current  policies,  the  flow  of  credit 
may only be normalised once broader macroeconomic conditions improve. 

•  The government deficit, although decreasing, remains elevated while government 
debt  is  high  and  increasing.  The  UK  is  currently  subject  to  the  Excessive  Deficit 
Procedure  of  the  Stability  and  Growth  Pact  and  to  the  Council  recommendations 
which  frame  the  adjustment  to  be  undertaken.  The  government  is  implementing  a 
fiscal consolidation programme and plan to continue it until the financial year 2017-
18,  after  having  extended  it  by  one  year  in  the  Autumn  Statement.  These 
developments will be discussed in detail in the European Commission's assessment of 
the UK Convergence Programme, as part of the European Semester in May 2013. 

The  IDR  also  discusses  the  policy  challenges  stemming  from  these  developments  and 
possible policy responses. A number of elements can be considered: 

the  UK's  persistent 

•  As regards the challenge of increasing external competitiveness, many of the drivers 
of 
that 
disproportionately impact upon capital-intensive sectors and goods' producers. Firstly, 
the competitiveness of the UK economy could be boosted by addressing shortages in 

to  structural  weaknesses 

trade  deficit 

relate 

4 

 
 
 
 
airport  and  seaport  capacity,  by  tackling  road  congestion  and  by  upgrading  the  rail 
network.  This would entail meeting the substantial transport infrastructure investment 
needs indicated in the National Infrastructure Plan 2011, much of which is currently 
unfunded, by identifying additional sources of funding, addressing high unit costs in 
transport,  and  removing  regulatory  barriers  to  investment.  Secondly,  industrial 
producers require a labour force with the correct advanced and intermediate technical 
skills, an area where evidence suggests that gaps and recruitment difficulties persist. 
Ensuring that the National Apprenticeship Programme effectively equips participants 
with  the  professional  and  technical  skills  demanded  by  the  tradable  sectors  of  the 
economy  can  contribute  to  closing  the  skills  gap  and  fostering  export  performance. 
Finally,  access  to  finance  is  crucial  for  UK  firms  seeking  to  enter,  or  expand  in, 
exporting sectors. Difficulties in accessing finance are a cross-cutting problem at the 
current juncture, particularly for smaller and younger companies. It is important that 
they  be  addressed  at  an  economy-wide  level  as  well  as  through  specific  financing 
instruments for exporting companies. 

•  Concerning  the  challenge  linked  to  deleveraging,  maintaining  financial  stability  and 
avoiding  unduly  compromising  investment  and  growth,  policy  needs  to  carefully 
balance a pressing need for new lending to support investment with a long term need 
for macroeconomic and financial stability. In the short term, loose monetary policy is 
appropriate in a context of weak domestic and external demand, but this should not be 
at  the  cost  of  allowing  existing  imbalances  to  remain  unresolved  indefinitely.  The 
government's  focus  on  broader  actions  to  improve  access  to  finance  are  also 
appropriate given that credit constraints are contributing to low investment and weak 
growth. To maximise the impact of the Funding for Lending Scheme and other access 
to finance policies they need to focus as far as possible on supporting an increase in 
productive  investment  rather  than  bidding  up  the  price  of  existing  assets.  Action  to 
address  the  problems  of  companies  with  limited  prospects  of  paying  back  their 
outstanding  debts  and  hidden  risks  in  bank  balance  sheets  –  namely  through  higher 
levels of provisioning by banks and, possibly, further company debt restructurings – 
could  both  deal  with  risks  to  the  stability  of  the  financial  system  and  support  the 
reallocation  of  resources  through  investment  in  more  productive  firms  and  sectors. 
Alleviating  the  housing  shortage  over  the  medium  term  would  reduce  the  risk  of 
imbalances related to persistently high house prices and household debt. This could be 
aided  by  further  liberalising  spatial  planning  laws,  ensuring  the  planning  system 
operates efficiently, and partially relaxing green belt restrictions. Moving toward flat 
rate  property  or  land  taxes  could  be  a  relatively  efficient  way  of  raising  additional 
revenue and improving the functioning of the land market. Making long-term private 
renting  more  attractive  by  giving  more  security  to  tenants  and  fostering  a 
professionalisation  of  the  sector  could  enhance  the  welfare  of  households  who  rent 
and help reduce the pressure on households to take on high levels of mortgage debt.  

5 

 
 
 
1. 

INTRODUCTION 

On  28  November  2012,  the  European  Commission  presented  its  second  Alert  Mechanism 
Report (AMR), prepared in accordance with Article 3 of Regulation (EU) No. 1176/2011 on 
the prevention and correction  of macroeconomic  imbalances. The AMR serves as an initial 
screening device helping to identify Member States that warrant further in-depth analysis to 
determine whether imbalances exist or risk emerging. According to Article 5 of Regulation 
No.  1176/2011,  these  country-specific  in-depth  reviews  (IDR)  should  examine  the  nature, 
origin and severity of macroeconomic developments in the Member State concerned, which 
constitute,  or  could  lead  to,  imbalances.  On  the  basis  of  this  analysis,  the  Commission  will 
establish  whether  it  considers  that  an  imbalance  exists  and  what  type  of  follow-up  it  will 
recommend to the Council. 

This is the second IDR for the UK. The previous IDR was published on 30 May 2012 on the 
basis  of  which  the  Commission  concluded  that  the  UK  was  experiencing  macroeconomic 
imbalances,  in  particular  as  regards  developments  related  to  external  competitiveness, 
household indebtedness and the housing market. Overall, in the AMR-2013 the Commission 
found it useful, also taking into account the identification of an imbalance in May, to examine 
further the persistence of imbalances or their unwinding. To this end this IDR takes a broad 
view of the UK economy in line with the scope of the surveillance under the Macroeconomic 
Imbalance Procedure (MIP). 

Against  this  background,  Section  2  of  this  in-depth  review  looks  more  in  detail  into 
developments covering both the external and internal dimensions of the UK economy. This is 
followed  by  a  specific  focus  on  external  competitiveness  and  the  level  and  dynamics  of 
private sector debt in Section 3. Section 4 discusses policy considerations. 

6 

 
 
2. 

MACROECONOMIC SITUATION AND POTENTIAL IMBALANCES 

2.1.  Macroeconomic scene setter 

The economic and financial crisis had a severe effect on the UK economy. Real GDP growth 
was  -1.0%  in  2008  and  -4.0%  in  2009,  mainly  as  a  result  of  large  declines  in  household 
consumption  and  private  investment.  Household  consumptions  fell  by  1.6%  in  2008  and 
3.1% in 2009, and private investment fell by 13.7% in 2009 alone. Unemployment1 jumped 
from 5.3% in 2007 to 8.0% in 2011, with youth unemployment2 reaching a historical high of 
21.1%  in  2011.  Despite  weak  GDP  growth,  inflation  remained  stubbornly  high  and  even 
increased  from  2.2%  in  2009  to  4.5%  in  2011.  This  was  mainly  as  a  result  of  imported 
inflation  following  a  fall  in  the  value  of  sterling  of  more  than  20%  over  2008-2009.  The 
current  account  deficit  remains  in  deficit,  with  goods  exports  lagging  but  the  exports  of 
services remaining more vibrant. 

The  fiscal  position  of  the  UK  deteriorated  rapidly  after  the  onset  of  the  crisis.  The  deficit 
increased  from  5.1%  to  11.5%  of  GDP  between  2008  and  2009  as  a  result  of  falling  tax 
revenue  and  increasing  expenditure,  owing  to  the  operation  of  automatic  stabilisers  and 
government injections in the financial sector. Government debt also rose substantially from 
52.3% in 2008 to 85.3% in 2011. 

The UK has experienced a slow, subdued and stuttering recovery from the financial crisis. In 
the final quarter of 2012, the level of real UK GDP was 3% below the pre-crisis peak in the 
first quarter of 2008 (per capita GDP is approximately 6% lower). GDP growth was just 0.2% 
in  2012  and  is  forecast  to  only  gradually  pick  up  in  2013  and  2014,  0.9%  and  1.9% 
respectively.3 

The unemployment rate peaked at 8.3% in the second half of 2011 but fell back to 7.8% in 
the third quarter of 2012. The recent fall in unemployment is surprising given the weakness 
of  GDP  growth.  Public  sector  employment  has  been  falling  every  quarter  since  the  third 
quarter of 2009 where it was 6.37 million, to 5.75 million in September 2012.4 This labour 
has been reallocated to the private sector, where employment has continued to increase, with 
recent  strong  growth  in  the  business  services  and  consumer  sectors.  In  the  third  quarter  of 
2012,  the  employment  rate5  reached  70.5%,  the  highest  rate  since  the  final  quarter  of  2008 
whilst the inactivity rate6 has remained relatively stable around 24.3% since 2005. 

The  strength  of  the  labour  market  has  been  surprising  given  the  recent  weakness  in  GDP, 
even  after  taking  into  account  the  possibility  of  data  revisions.  Labour  hoarding,  weak  real 
wages  and  an  increase  in  part-time  work  and  self-employment  account  for  part  of  this 
phenomenon. The consequence of weak GDP growth combined with a resilient labour market 
has been a marked drop in labour productivity. It is unlikely that the unemployment rate can 
continue falling given the weak growth outlook. Unemployment may have reached its trough 
and it is forecast to increase to 8.0% in 2013 before falling back to 7.8% in 2014. 

1 Eurostat definition for total unemployment: less than 25 years and 25-74 years. 
2 Less than 25 years. 
3 Forecasts stem from the Commission services' 2013 Winter Forecast. 
4 It should be noted that Further Education Corporations and Sixth Form College Corporations in England were classified as public sector 
until  March  2012  and  as  private  sector  from  June  2012.  These  educational  bodies  employed  196,000  people  in  March  2012  and  the 
reclassification therefore results in a large fall in public sector employment and a corresponding large increase in private sector employment 
between March and June 2012. 
5 Eurostat definition: 15-64 years. 
6 Eurostat definition: 15-64 years. 

7 

 
 
                                                            
Inflation has mostly been on a general downward trajectory since September 2011 where it 
peaked at 5.2%. Inflation was 2.7% in the final three months of 2012 and the first month of 
2013, up from 2.2% in September. This increase is largely due to temporary factors such as 
the  increase  in  tuition  fees  in  England  in  October  and  rises  in  utility  prices.  However, 
inflation  is  still  expected  to  fall  given  weak  demand,  but  at  a  slower  rate  than  previously 
forecast. Inflation is estimated at 2.6% in 2013 and 2.3% in 2014. 

The UK economy's adjustment capacity is affected by the degree of flexibility of its product 
and labour markets. According to international benchmarks, UK product markets are among 
the  least  regulated  in  the  EU  and  worldwide,  and  its  business  environment  is  generally 
favourable. With no large collective bargaining arrangements outside the public sector, which 
has seen widespread pay freezes, and very little automatic wage indexation, real wages have 
been falling for three years. While this has had a negative impact on household consumption, 
it has also helped to limit increases in unemployment. The UK's flexible labour and product 
markets remain a strength but low public and private investment, impaired credit flows, and a 
resulting  low  level  of  churn  in  the  economy  could  all  impair  the  effective  reallocation  of 
resources in response to the shocks that the UK economy has experienced. 

Competitiveness and export performance 

2.2. 
The  UK  experienced  large  losses  in  global  market  shares,  in  both  value  and  volume7 
terms, in 2007, 2008 and 2010, before returning to stability in 2011, as shown in Graph 1. 
A  secular  trend  of  dwindling  export  market  shares  has  been  the  experience  of  many 
developed  economies  due  to  the  emergence  of  highly  competitive  and  faster  growing 
economies, in particular in Asia. The UK, however, appears to have been more affected than 
most,  displaying  the  highest  losses  in  the  EU-27  according  to  the  export  share  scoreboard 
indicator of the AMR-2013.  

Graph 1: UK export market share growth 

30

20

10

0

-10

-20

-30

-40

)

%

(

y
-
o
-
y
e
g
n
a
h
c

f
o
e
t
a
R

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Denominator: World Export growth (neg. sign)
Numerator: Export growth
EMS growth rate

Source: Commission services 

Since  1997,  the  UK  current  account  has  been  in  a  persistent,  albeit  moderate,  deficit, 
which amounted to -1.3% in 2011. The current account data for 2012 surprised on the 

7 Although the scoreboard indicator on market shares is measured in value terms and is thus affected by movements in the sterling exchange 
rate, section 3.1 shows that export shares in volume terms also decreased markedly when controlling for the offsetting and largely coincident 
effects of a depreciation in sterling in 2008-2009 and an increase in prices by UK exporters. 

8 

 
 
 
 
 
 
 
 
                                                            
downside due to weak net trade and investment income, combined with resilient import 
dynamics. The current account deficit is forecast to have increased to 3.7% of GDP in 2012. 
This  outcome  was  essentially  due  to  unfavourable  cyclical  conditions  rather  than  a 
fundamental deterioration in external competitiveness. In particular, the demand faced by UK 
exporters  was  constrained  by  unfavourable  developments  in  foreign  markets,  namely  in 
Europe, which have also contributed to reduce the income inflows from foreign investment. 
Additionally, perturbations in the production of North Sea oil and gas and lower remittances 
from abroad have also had a negative effect on the current account. 

The UK trade balance is characterised by dynamic service exports which, however, do 
not  fully  compensate  for  the  chronic  deficit  in  goods,  as  depicted  in  Graph  2.  The  crisis 
period which started in 2007 saw a halting in the widening of the trade in goods deficit as a 
percentage  of  GDP,  which  has  hovered  between  6%  and  7%  in  recent  years.  On  the  other 
hand,  the  surplus  in  trade  in  services  has  continued  to  grow  to  reach  4.7%  in  2011,  even 
though its evolution has been partially affected by a drop in foreign demand for financial and 
related services in the wake of the global financial crisis. 

The UK has historically benefited from positive foreign income inflows, although these 
have  weakened  in  2012.  The  high-yielding  foreign  assets  held  by  UK  domestic  agents, 
namely in the form of foreign direct investment (FDI), have permitted the UK to derive net 
inflows from  a  negative net international  investment position (NIIP). These, however, have 
been  decreasing  since  2008,  turning  negative  in  the  first  half  of  2012.  This  was  due,  in 
particular,  to  the  lower  profitability  of  investments  in  Europe8.  The  independent  Office  for 
Budget Responsibility expects investment income to return to positive ground in 2013 and to 
remain  stable  over  its  forecast  horizon.9  Current  transfers  have  historically  been  negative, 
reflecting government transfer outflows and the effects of remittances (the UK is a recipient 
of net immigration inflows). 

Graph 2: Decomposition of the UK current 
account 

8

6

4

2

0

-2

-4

-6

-8

P
D
G

f
o
%

-10

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12*

Capital account (KA)
Current transfers
Income balance
  Trade balance - services
  Trade balance - goods
Trade balance
Current account balance (CA)
Net lending/borrowing (CA+KA)

Source: Commission services 
*Estimated 

After  a  sharp  depreciation  in  2007-2009,  the  real  effective  exchange  rate  (REER) 
remained  relatively  stable  in  2011  and  appreciated  somewhat  in  2012.  As  shown  in 

8 It should be noted that initial estimates of foreign income flows are uncertain and subject to revision. 
9 Office for Budget Responsibility (2012). 

9 

 
 
 
 
                                                            
Graph 3, these movements have been mostly driven by swings in the nominal exchange rate. 
The sharp nominal depreciation in the wake of the crisis contributed to stabilise the trade in 
goods  deficit,  which  had  been  increasing  since  1997,  when  sterling  entered  a  decade-long 
period  of  relative  strength.  The  confidence  crisis  in  parts  of  Europe  contributed  to  the 
appreciation  of  sterling  in  2012  which,  coupled  with  an  inflation  rate  that  has  remained 
persistently  above  target,  has  led  to  a  higher  REER  in  2012.  However,  sterling  started 
weakening towards the end of 2012 and beginning of 2013. 

Graph 3: Decomposition of developments in 
the UK REER 

10

5

0

-5

)

%

(

y
-
o
-
y
e
g
n
a
h
c

f
o
e
t
a
R

-10

-15

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

NEER
REER (HICP)

relative HICP (-)
REER (ULC)

Source: Commission services 

Unit  labour  costs  (ULCs)  have  increased  moderately  in  recent  years  due  to  high 
inflation  and  weak  labour  productivity,  which  is  the  result  of  a  surprisingly  strong 
labour market in a context of weak or negative growth. Even though real ULCs decreased 
in 2011 as nominal wages continued to grow below inflation, nominal ULC growth in the UK 
has outpaced that of the euro area, thereby contributing to erode the competitiveness of the 
UK  vis-à-vis  its  main  trading  partners  (Graph  4).  However,  even  taking  into  account  the 
recent  appreciation  of  sterling,  the  strong  2007-2008  nominal  depreciation  has  so  far  been 
sufficient in offsetting the cumulated increases in ULCs from a strict price competitiveness 
point of view. 

10 

 
 
 
 
 
 
Graph 4: Decomposition of developments in 
the UK Unit Labour Costs 

)

%

(

y
-
o
-
y
e
g
n
a
h
c

f

o
e

t

a
R

8

6

4

2

0

-2

-4

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Inflation (GDP deflator growth)
Real Compensation per Employee
Productivity Contribution (negative sign)
Nominal unit labour cost
ULC in Euro Area

Source: Commission services 

UK  current  account  deficits  have  generally  been  funded  by  portfolio  investment  into 
UK  securities,  such  as  shares  and  bonds,  and  by  other  investments  such  as  loans  (see 
Graph  5).  By  contrast,  the  UK  built  up  a  positive  international  position  in  FDI  by  being  a 
foreign  direct  investor  in  most  years.  This  funding  profile  has  been  relatively  stable  over 
time, although the crisis year of 2008 was remarkable for its inflows of portfolio investment 
and its outflows in other investments, namely in the form of deposit flights. 

Overall,  the  persistence  of  competitiveness  shortfalls  merits  attention  as  a  possible 
source  of  macroeconomic  imbalances.  As  such,  Section  3.1  further  analyses  external 
competitiveness developments in the UK.  

Graph 5: Financing of the UK current 
account 

25

20

15

10

5

0

-5

-10

-15

-20

-25

P
D
G

f
o
%

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12*

Net errors and omissions
Official reserves (net)
Other investment (net)
Portfolio investment (net)
Direct investment (net)
Current account balance
Net lending/borrowing (CA+KA)

Source: Commission services 
*Estimated 

11 

 
 
 
 
 
 
 
 
 
2.3. 

Sustainability of external positions 

The NIIP displayed a noticeable improvement, from -24% in 2010 to -17% in 2011 due 
to valuation changes, rather than a shift in the fundamentals. In fact, a negative current 
account in 2011 and 2012 has contributed negatively to the IIP, which deteriorated in 2012. 
Valuation changes in 2011 do not appear to have been caused by movements in the exchange 
rate but may have been partly driven by a drop in the UK stock market10 and an increase in 
the nominal value of foreign direct investment abroad. 

Overall,  the  UK  has  maintained  a  modestly  negative  NIIP  since  the  late  1990s,  which 
has  not  prevented  it  from  deriving  a  net  positive  income  inflow.  In  fact,  as  shown  in 
Graph  6,  UK  foreign  external  assets  are  dominated  by  high-yielding  assets  such  as  direct 
investments, which have historically offset larger but lower-yielding liabilities in the form of 
loans, bonds and deposits in UK banks. Evidence suggests that the UK has also managed to 
extract higher returns from its foreign asset base, even after controlling for its composition. 
The  denomination  of  the  NIIP  is  also  a  generally  favourable  one  whereby  most  liabilities 
have been taken up in the domestic currency. 

Although  the  evolution  of  the  UK  NIIP  is  rather  volatile  due  to  erratic  valuation 
changes  (Graph  7),  it  remains  well  within  the  scoreboard  indicator  threshold  of  -35% 
and  appears  to  be  sustainable  in  the  medium  term.  According  to  Commission  and 
consensus  estimates,  the  UK  current  account  is  expected  to  move  closer  to  the  NIIP-
stabilising  value,  which,  excluding  valuation  effects,  should  preclude  a  rapid  and  sustained 
deterioration of the NIIP in the medium term. 

Graph 6: Decomposition of the UK net 
international investment position 

Graph 7: Decomposition of changes in net 
international investment position 

50

0

P
D
G

f

o
%

-50

-100

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 1112*

Net portfolio investment
Changes in reserves (net)
Other investment (net)
Net direct investment
Net financial derivatives
Net external debt (neg. sign)
Net int'l investment position (NIIP)
Marketable debt (portfolio debt instr. and other investment, net)

Source: Commission services 
* Estimated 

)

%

(

y
-
o
-
y
e
g
n
a
h
c

f
o
e
t
a
R

30

20

10

0

-10

-20

-30

05Q4 06Q4 07Q4 08Q4 09Q4 10Q4 11Q4

Valuation changes
Net transaction effect (rest FA bal.)
Investment income effect
Nominal growth effect
Change in NIIP (y-o-y)

Source: Commission services 

2.4. 

Government indebtedness  

The general government deficit fell to 7.8% of GDP in 2011, after spiking at 11.5% in 
2009. The Commission services' Winter forecast estimates a deficit of 6.3% in 2012, which 

10 The stock market is counted in part as foreign liabilities, reflecting foreign equity investment in UK companies. 

12 

 
 
 
 
 
 
 
 
 
                                                            
includes  a  one-off  Royal  Mail  pension  fund  transfer  of  GBP  28  billion  (approx.  1.8%  of 
GDP), 7.4% in 2013, which includes the sale of 4G mobile phone licences and 6.0% in 2014. 

The  debt  ratio  was  85.2%  in  2011  and  is  forecast  at  89.8%  in  2012.  It  is  expected  to 
continue increasing in 2013 and 2014 and reach 95.4% and 97.9%, respectively (Graph 
8). This is far above  the 60%  threshold specified in  the scoreboard indicators  and the 
Maastricht  threshold.  In  the  Autumn  Statement11,  the  UK  government  has  continued  its 
fiscal  consolidation  plans  without  any  major  changes  to  the  general  thrust  of  the  strategy. 
Some adjustments were made by substituting current for capital spending but within the same 
expenditure envelope and the period of consolidation was extended by one further year to the 
financial year (FY) 2017-18. Due to the impact of weak GDP growth on public finances, the 
deficit is unlikely to fall exceptionally quickly despite a considerable decrease in government 
expenditure as part of the government's multi-year consolidation programme. However, due 
to some one-off transfers into the general government accounts, the deficit figure looks better 
than the underlying position.12 

Graph 8: UK government debt 

P
D
G

f

o
%

120

100

80

60

40

20

0

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12*13*14*

Source: Commission services 
*Forecast 

The UK has been under the Excessive Deficit Procedure (EDP) since July 2008. In 2009, 
acknowledging the worsening macroeconomic situation and the need to support growth in the 
short term, the Council adopted a decision and recommendation that led to the extension of 
the  EDP  deadline  to  2014-15.  The  UK  fiscal  position  will  be  discussed  in  detail  in  the 
assessment  of  the  UK  Convergence  Programme  to  be  carried  out  in  a  forthcoming 
Commission Staff Working Document. 

It is not clear how much of the recent drop in UK sovereign yields has been driven by 
increasing  confidence  in  the  UK's  fiscal  position.  Yields  are  likely  to  have  been 
depressed  by  quantitative  easing,  international  financial  flows  in  the  midst  of  a 
confidence  crisis  affecting  the  euro  area,  and  (perversely)  by  weakening  growth 
prospects which have reduced expectations of future interest rate rises. This has led to 

11 HM Treasury (2012). 
12  Apart  from  taking  over  the  Royal  Mail  pension  fund  in  April  2012,  which  reduced  the  deficit  by  1.8  pp.  that  year  and  the  sale  of  4G 
mobile  phone  licences  in  March  2013,  which  reduced  the  deficit  by 0.1pp.  approx.,  both one-off  effects,  the  government  also  decided  to 
transfer the excess cash held at the  Bank of England's Asset Purchase Facility to the general government accounts. The treatment of this 
transfer,  including  the  expected  future  flow  of  the  coupon  payments  on  the  gilts  had  not  been  confirmed  by  Eurostat  at  the  time  of  the 
forecast and therefore does not feature in the Commission services’ Winter forecast. 

13 

 
 
 
 
                                                            
very favourable interest rates on public debt. While it is difficult to predict the timing, speed 
or  direction  of  any  change  to  this  situation,  a  return  to  interest  rates  more  consistent  with 
historical  trends  may  have  a  significant  impact  on  the  capacity  of  both  the  public  and  the 
private  sectors  to  honour  interest  payments  without  further  squeezing  investment  and 
consumption. 

As shown in Graph 9, the general government sector remains a significant net borrower 
in the economy. By contrast, households are net lenders since 2009 but this has been falling 
in recent years. Both financial and non-financial corporations are net lenders to the economy 
since  2002.  The  details  of  private  sector  indebtedness  will  be  discussed  in  Section  2.5  and 
further in 3.2.2. 

Graph 9: Net lending or borrowing by 
sector 

15

10

5

0

P
D
G

f

o
%

-5

-10

-15

99 00 01 02 03 04 05 06 07 08 09 10 11

Households
Financial corporations
Total Economy

General government
Non-Financial corporations

Source: Commission services 

2.5. 

Private sector indebtedness 

Private  sector  debt  as  a  share  of  UK  GDP  increased  steadily  and  significantly,  from 
123% of GDP in 1995 to a peak of 221% in 2008, and has since fallen back to 206% in 
2011.  This  is  well  above  the  scoreboard  indicator  threshold  of  160%.  The  ratio  of  private 
sector debt to GDP can be disaggregated into non-financial corporation (NFC) debt of 110% 
and  household  debt  of  96%,  as  depicted  in  Graph  10.  The  debt  of  financial  corporations, 
which is considered separately to other private debt, swelled sharply in the crisis and remains 
high.  There  has  been  some  progress  in  deleveraging  in  both  the  corporate  and  household 
sectors, due at least as much to flows of new lending remaining unusually low as to existing 
debt stocks being paid off or written off. 

14 

 
 
 
 
 
Graph 10: Decomposition of financial 
liabilities in the UK economy 

1000

P
D
G

f
o
%

900

800

700

600

500

400

300

200

100

0

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 1112*

Financial corporations
Household
Private sector EA17
Private sector

Government
Non financial corporations
MIP Threshold

Source: Commission services 

Credit flows to the private sector as a whole remain muted 

The  net  flow  of  credit  to  the  private  sector  in  2011  as  a  whole  was  muted,  with  1% 
growth, and net credit trends remained weak throughout 2012. The rate of growth in the 
stock of lending to UK businesses was -4.1% in the year to November 2012, while secured 
lending to households rose by 0.6% over the same period.13 This is in sharp contrast to the 
abundant  credit  flows  to  UK  firms  and  households  in  the  pre-crisis  years.  Net  credit  to 
households averaged 8.7% of GDP per annum in the decade to 2007 compared to just 3.8% 
for the euro area, as shown in Graph 11. This, combined with the average net credit flows to 
NFCs  of  8.9%  in  the  same  period,  led  the  UK  to  exceed  the  15%  scoreboard  indicator 
threshold for private sector credit flows every year from 1999 to 2007.  

The  UK  private  sector  has  tightened  its  lending  more  sharply  than  the  euro  area 
average. After a sharp correction during the crisis in 2009, when investment collapsed, credit 
flows  to  NFCs  are  weak  but  show  signs  of  bottoming  out  and  financing  conditions  vary 
significantly  across  sectors  and  firm,  as  discussed  in  Section  3.  Larger  firms  with  strong 
balance sheets are able to borrow at a historically low cost but many other firms, particularly 
SMEs,  are  credit  constrained.  Financial  corporations  have  moved  to  being  significant  net 
savers  as  they  consolidate  their  balance  sheets.  A  low  level  of  housing  transactions  and 
tighter mortgage lending criteria has reduced credit flows to households.  

13 Bank of England (2013b). 

15 

 
 
 
 
                                                            
Graph 11: Decomposition of net credit flows 
in the economy 

P
D
G

f
o
%

35

30

25

20

15

10

5

0

-5

-10

-15

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12*

Financial corporations
Household
Private sector EA17
Private sector

Government
Non financial corporations
MIP Threshold

Source: Commission services 
Note: Non-consolidated data. Figures for each sector are the 
sum of the flow of loans and securities other than shares. 

Recent gradual deleveraging of NFCs has been driven by low investment 

While the debt of NFCs has fallen slightly since 2008, business investment has remained 
at  a  very  low  level  and  the  stock  of  lending  to  UK  businesses  has  been  falling 
consistently since 2009.14 An unprecedented drop in business investment after 2007 saw the 
UK level of gross fixed capital formation as a share of GDP fall to 14.2 % in 2011, the third 
lowest level in the EU-27. Business investment has started to pick up slightly, with an annual 
increase of 5.1% to the third quarter of 2012, but remains low. Public investment has been cut 
sharply as part of the government's fiscal consolidation programme. The low investment rate 
is  due  not  only  to  the  low  share  of  capital-intensive  manufacturing  in  GDP  but  also  to  the 
combined effects of an uncertain and unfavourable economic environment and difficulties in 
accessing finance, especially on the part of small and medium companies.  

Structural features partly explain the higher leverage levels of UK companies compared 
to the euro area average. The UK has a relatively large share of output generated by large 
companies and by multinationals, both of which are associated with higher levels of leverage, 
and investment. Multinational companies, in particular, are able to service debt taken up in 
the UK with revenue streams from overseas. The corporate sector in the UK is also likely to 
be more integrated, for example making use of inter-company loans, which also tends to raise 
the headline unconsolidated debt figures. 

Household debt falling from historic highs, mainly due to a low volume of new lending  

The run-up to the crisis saw the housing market overheat, with house price-to-income 
ratios  reaching  historic  highs  in  the  context  of  a  growing  housing  supply  shortage, 
leading to the accumulation of high levels of mortgage debt. The level of household debt 
rose from 69% of GDP in 2000 to a peak of 104% in 2009 and the 2012 in-depth review of 
the  UK  concluded  that  high  household  debt,  around  85%  of  which  is  mortgage  debt, 
constitutes an internal imbalance in the UK economy. Graph 12 shows that net deleveraging 
of households started in 2009 measured against gross disposable income, or 2010 measured 

14 Bank of England (2013b). 

16 

 
 
 
 
                                                            
against  GDP  (GDP  fell  more  sharply  than  disposable  income  in  the  recession).  In  2011, 
household  debt  fell  from  99.6%  of  GDP  to  96%,  against  a  euro  area  average  of  64%.  As 
discussed  in  Section  3,  to  date  household  deleveraging  has  been  driven  mainly  by  an 
abnormally  low  level  of  housing  transactions  although  the  household  saving  rate  has  also 
picked up to 7.7% in the third quarter of 2012.  

Graph 12: Household leverage indicators 

s
t
e
s
s
a

d
n
a
P
D
G

f
o
%

120

100

80

60

40

20

0

I

D
G
%

180

160

140

120

100

80

60

40

20

0

95

97

99

01

03

05

07

09

11

Debt / GDP, Households
Debt / fin. assets, Households
Debt / gross disposable income, Households (right axis)

Source: Commission services 

Households have significant net assets but this masks growing inequality in net worth 

UK  households  have  substantial  net  assets  in  aggregate,  but  these  have  become  more 
concentrated.  The  financial  assets  of  UK  households,  which  exclude  (significant)  housing 
wealth but include illiquid pension funds, were 183% of GDP in 2011, well above the euro 
area  average  of  128%.  UK  households  have  relatively  high  levels  of  both  gross  assets  and 
gross liabilities, which in large part reflects the effects of high house prices. The  impact of 
rising asset prices in driving gross household leverage is shown in Graph 14, which depicts 
an  alternative  way  of  viewing  household  leverage  ratios.  The  upper  line  shows  that  if  one 
removes  valuation  effects,  households'  previously  apparent  stable  debt-to-assets  ratio  is 
actually  increasing  over  the  boom  years.  This  is  also  the  case  for  Sweden,  although  in 
Sweden it is largely the same households that hold assets and liabilities.15 While the average 
net asset position of UK households has been quite stable over the last decade, net wealth has 
become more polarised by income, tenure and across the life cycle. Net wealth has become 
increasingly  concentrated  in  older  households,  with  the  ratio  of  median  net  worth  among 
households  aged  45+  to  those  aged  18-34  rising  from  1.9  to  3.7  between  2005  and  2012.16 
The  net  wealth  of  younger  households  has  fallen,  whether  they  are  renting  or  mortgage 
holders, and a growing minority have negative net wealth. These trends are likely to increase 
the macroeconomic risks associated with a given household debt stock. 

15 European Commission (2012d). 
16 Whittaker (2012). 

17 

 
 
 
 
 
 
 
                                                            
Graph 13: Households debt-to-assets ratio 

Source: Commission services 

Residential construction also remains weak but house prices are still high 

High house prices are linked to a shortage of housing supply, which is linked in turn to 
a scarcity of land available for development.17 As discussed in Section 3.2, the government 
has put in place a number of measures to reform the restrictive spatial planning system and 
provide financial support to residential developers and first-time buyers, but it is not yet clear 
how effective these will be in boosting the supply of housing. UK housing completions rose 
slightly from a low of 137,000 in 2010-2011 to 146,000 in 2011-2012, but as shown in Graph 
14  the  level  of  housing  completions  remains  historically  low.  The  most  recent  forward 
looking data, show annual housing starts in England (UK data are not yet available) totalling 
98.280 in 2012, a decrease of 11% compared to 2011.18 

Graph 14: UK dwelling completions by type 

Source: Department for Communities and Local Government 

As Graph 15 shows, UK real house prices have fallen from their peak in 2007 but still 
remain well above the levels before the house price boom of the 2000s. The run-up to the 

17 Hilber and Verleulen (2012). 
18 Department for Communities and Local Government (2013). 

18 

 
 
 
                                                            
crisis  saw  the  housing  market  overheat,  with  house  price-to-income  ratios  reaching  historic 
highs  and  the  accumulation  of  high  levels  of  mortgage  debt.  Since  2007,  the  average  real 
house  price  has  fallen  by  17%  but  the  average  nominal  house  price  is  only  4%  below  the 
peak. After falling sharply in 2009, UK house prices rebounded by 10% by mid-2010, after 
which time nominal house prices have been relatively flat. 

Graph 15: Developments in UK house prices 
and mortgage lending19 

30.0

25.0

20.0

15.0

10.0

5.0

0.0

-5.0

)

%

(

y
-
o
-
y
e
g
n
a
h
c

f
o
e
t
a
R

-10.0

-15.0

140

120

100

80

60

40

20

0

0
0
1
=
5
0
0
2

99Q4 01Q4 03Q4 05Q4 07Q4 09Q4 11Q4

MFI loans for house purchase (% GDP, yoy)
Real House Price Index (2005=100), right axis
Nominal House Price Index (2005=100), right axis

Source: Commission services, ECB 
Overall,  high  household  debt,  stemming  mainly  from  mortgage  lending  on  expensive 
houses,  a  continuing  housing  supply  shortage  and  uncertain  prospects  for  household 
deleveraging,  warrants  further  investigation  as  a  source  of  potential  macroeconomic 
imbalances. This topic, along with a closer look at corporate debt, are further developed in 
Section 3.2. 

3. 

IN-DEPTH ANALYSIS OF SELECTED TOPICS 

3.1. 

External competitiveness 

This  section  assesses  developments  in  external  competitiveness  in  the  UK  and  reviews 
the  structural  characteristics  of  the  UK  trading  sector,  identifying  its  main  strengths 
and  possible  bottlenecks.  It  follows-up  on  the  2012  in-depth  review  (IDR)  of  the  UK 
economy20  and  on  the  AMR-201321  which  were  published  under  the  Macroeconomic 
Imbalances Procedure. 

As captured in the AMR-2013 scoreboard indicator, losses in UK export market shares 
in  the  five  years  to  2011  were  the  highest  of  all  EU  member  states  (-24.2%).  Although 
UK market shares remained broadly stable in 2011, large losses occurred in 2007, 2008 and 
2010. This result was partially driven by the sharp depreciation of sterling that took place in 
2008-2009  which  reduced  the  value  of  UK  exports  when  measured  in  a  common  currency. 
However,  UK  exporters  counteracted  the  effects  of  the  depreciation  to  a  large  extent  by 
increasing  their  sterling-denominated  prices.  Therefore,  when  considering  simultaneously 
exchange rate and export price developments, it is clear that they offset each other to a large 

19 Nominal and real house price index (2005=100). Year-on-year change in the loans for house purchase granted by MFIs (as a % of GDP). 
Source: Eurostat, ECB.  
20 European Commission (2012e). 
21 European Commission (2012f). 

19 

 
 
 
 
 
 
 
                                                            
extent,  the  result  being  that  a  large  drop  in  export  market  shares  is  still  evident  when 
controlling for these price effects (see Table 122). 

Table 1: UK Export Market Shares (y-o-y growth, value terms)

Actual
Exchange rate corrected1
Exchange rate and export prices corrected2

2004
-3.4%

2005
-4.7%

2006
-0.2%

2007
-8.3%

-7.9%

-7.5%

2008
-10.1%

4.6%

-5.6%

2009
0.5%

12.5%

10.7%

2010
-7.1%

-10.5%

-13.5%

2011
-1.6%

-0.4%

-4.7%

2006-11
-24.2%

-3.5%

-20.2%

1) Expo rt market shares ho lding the average 2006 EUR-GB P exchange rate co nstant

2) Expo rt market shares ho lding the average 2006 EUR-GB P  exchange rate co nstant and assuming expo rt price gro wth in line with 1999-2006 average gro wth

Unlike  in  AMR-2012,  the  3-year  change  in  the  REER  no  longer  breached  the 
scoreboard  indicator  threshold  in  AMR-2013.  This  is  due  to  the  fact  that  the  large 
depreciation  in  2008  has  since  dropped  out  of  the  scoreboard  indicator  calculations.  The 
REER  remained  broadly  stable  in  2011  and  appreciated  somewhat  in  2012  driven  by 
sterling's strength during most of the year. 

As will be seen in this Review, there is no single dominant factor explaining the external 
underperformance of the UK economy, although a number of structural constraints are 
apparent.  Overall,  the  external  dimension  of  the  UK  economy  is  less  a  source  of 
macroeconomic 
instability,  and  more  a  field  of  often  underexploited  growth 
possibilities. Section 3.1.1 starts by presenting recent competitiveness developments which, 
in  2012,  took  place  in  an  unfavourable  external  economic  context  and  resulted  in  a  worse-
than-expected trade performance. Section 3.1.2 then reviews the structural characteristics of 
UK trade and its exporting sector, identifying strengths and weaknesses. Section 3.1.3 delves 
deeper  into  specific  bottlenecks  in  infrastructure,  skills  and  access  to  finance.  Section  3.1.4 
concludes. 

As discussed in the present section, the external competitiveness challenges identified in 
the 2012 IDR remain valid.  

3.1.1.  Developments in external competitiveness 

A  worse-than-expected  outturn 
circumstances 

in  2012, 

largely  driven  by  unfavourable  external 

The UK posted a small but significant current account deficit of -1.3% of GDP in 2011, 
which  is  forecast  to  have  deteriorated  to  -3.7%  in  2012.  This  was  due  to  low  export 
growth, weaknesses in investment income inflows, in particular from EU countries, a buoyant 
import demand given the domestic recession and lower remittances from abroad. 

The external economic context in 2012 was not the most favourable one for European 
exporting companies, the UK's included. Weak and negative growth the in EU, the largest 
single  market  for  UK  exports  (representing  47%  in  2011)  has  constrained  the  expansion  of 
the UK's external demand. In 2012, the percentage of manufacturing firms citing "political or 
economic  factors  abroad"  as  a  factor  limiting  exports  reached  40%,  the  highest  value  in  a 
decade (Graph 16).  

22  Behavioural  effects  on  export  quantities  are  ignored.  Controlling  additionally  for  these  effects  would  mean  a  larger  drop  in  estimated 
market shares in recent years.   

20 

 
 
 
                                                            
Graph 16: UK firms citing factors abroad 
as inhibiting exports 

60

50

40

%

30

20

10

0

00 01 02 03 04 05 06 07 08 09 10 11 12 13

Source: CBI Industrial Trends Survey 

Not  only  foreign-income  effects,  but  also  price  effects  are  presently  affecting  the  export 
performance of the UK. The appreciation of sterling in trade-weighted terms during most of 
2012  may  deliver  negative  contribution  to  export  volumes,  while  higher  oil  prices  have 
contributed  to  the  deterioration  of  the  oil  trade  balance.  The  recent  depreciation  of  sterling 
vis-à-vis the euro can, however, provide some support going forward. 

The current account is expected to improve in the medium term. Commission forecasts 
currently  estimate  the  current  account  balance  at  -3.1%  in  2013  and  -2.0%  in  2014.  The 
Office for Budge Responsibility expects net trade to contribute 0.2 pp. on average per year to 
GDP  growth  between  2013  and  2017.  It  also  expects  the  current  account  deficit  to 
progressively narrow until 2017, when it is projected at approximately -1.5% of GDP. 

The dynamism of UK service exports has not managed to compensate for the large deficit in 
trade in goods 

The UK is the largest services exporter in the EU and its services trade balance posted a 
surplus worth 4.7% of GDP in 2011, as shown in Graph 17. In the pre-crisis period running 
from  2000-2007  the  UK  continued  to  increase  its  global  market  share  in  services  exports, 
even as its goods share declined more than any other EU country. After 2007 and until 2011 
UK market shares were subject to a double setback. Not only did the share of goods' exports 
continue falling, but services exports also experienced negative developments (see Graph 19). 
Although the nominal value of total service exports continued to grow in this period, its pace 
was significantly slowed down by a decline in exports of financial and insurance services (see 
Graph 18). 

21 

 
 
Graph 17: International market shares of 
the six largest service exporters in the EU 

Graph 18: Developments in UK aggregate 
and financial services exports 

Source: Commission services 

Source: Commission services 
* Estimated 

Graph 19: UK export market share growth 
decomposition 

6

4

2

0

-2

-4

-6

-8

-10

-12

)

%

(

y
-
o
-
y
e
g
n
a
h
c

f

o
e

t

a
R

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Contribution to EMS: goods
Contribution to EMS: services
Export market share growth yoy

Source: Commission services 

The  UK  has  experienced  a  negative  trade  balance  in  goods  since  1983,  which  started 
deteriorating markedly after 1997. Its value stabilised a little below 7% of GDP in recent 
years. 

Although  UK  external  trade  has  underperformed  for  several  years,  it  should  be 
acknowledged  that  some  degree  of  rebalancing  towards  net  exports  has  taken  place. 
From 2007 to 2011 export volumes increased by 3.3%, a time when GDP contracted by 
2.3%. In fact, net trade delivered a positive contribution to GDP growth in every year during 
this period, with the exception of 2010. 

The post-crisis depreciation of sterling provided only a modest boost 

Sterling depreciated sharply in 2008-2009, after a decade of strength which saw the UK 
trade  balance  deteriorate  markedly  (see  Graph  20).  Notwithstanding  this  exchange  rate 
correction,  Commission  services'  analysis  of  the  equilibrium  exchange  rate  suggests  that 
22 

 
 
 
 
 
 
 
sterling may have remained slightly overvalued during most of 2012. The drop in sterling vis-
à-vis the euro towards the end of 2012 and beginning of 2013 may thus mean a movement 
towards equilibrium values. The recent depreciation of sterling can also be understood as the 
consequence  of  the  resolution  of  uncertainties  regarding  the  euro  area  crisis,  concerns  over 
UK  public  finances,  expectations  of  further  quantitative  easing  and  rising  uncertainties 
regarding the UK’s future relationship with the EU. 

Graph 20: UK exchange rate and trade 
balance performance 

Source: Commission services 

The depreciation of sterling was not, however, sufficient to put the trade balance on a 
sustained  upward  trend.  This  could  be  due  to  a  number  of  factors.  Firstly,  exporters 
compensated for the depreciation by raising their sterling-denominated prices. The fact that 
exporters  opted  to  increase  their  margins  rather  than  expand  market  shares  and  invest  in 
capacity may be due to uncertainties regarding the likelihood of sterling remaining at its new 
low level and a cautious approach in the face of a volatile external environment. However, as 
sterling  remains  at  a  relatively  low  level,  exporters  strengthen  their  balance  sheets  and 
uncertainty  resolves,  expansion  should  become  an  increasingly  attractive  option.  Secondly, 
the depreciation contributed to raise input prices for some exporters. Thirdly, the depreciation 
took place at the same time as the external demand for UK goods collapsed due to the global 
financial and economic crisis, which would mask the positive effects accruing from the new 
exchange  rate.23  These  factors  have  been  highlighted  in  a  recent  survey  of  manufacturers 
where  the  global  economic  downturn,  rising  input  costs  and  significant  movements  in  the 
exchange rate were cited as the three foremost risks to growth.24 

Finally,  as  discussed  in  subsection  3.1.3,  a  number  of  bottlenecks  are  constraining  the 
external performance of the UK. 

Competitiveness  losses  and  unfavourable  geographical  specialisation  drove  the  post-crisis 
fall in market shares 

In  the  pre-crisis  period  of  2000-2007,  UK  export  markets  grew  in  line  with  the  world 
average. In this period, the geographical markets in which the UK was specialised, especially 
European markets, were growing in line with global trends. Likewise, the product markets in 

23  The  average  estimate  for  the  price  elasticity  of  UK  exports  has  been  estimated  at  -0.4,  the  same  as  the  price  elasticity  of  imports.  By 
contrast, the income elasticities of exports and imports tend to be higher and are often found to be unitary. See Bank of England (2011). 
24 EEF (2013). 

23 

 
 
                                                            
which  the  UK  was  specialised  were  growing,  on  aggregate,  in  line  with  overall  product 
markets. In this  period decreases  in market  shares  were thus  due  to  competitiveness losses, 
namely with respect to fast-growing emerging economies. 

losses 

In the post-crisis period of 2007-2010 UK exports were affected by their focus on slow-
growing  markets,  competitiveness 
in  geographical  destinations  and  by 
competitiveness losses in product markets (Graph 21). In fact, the traditional geographical 
markets  to  which  the  UK  exported,  namely  advanced  economies  in  Europe,  slowed  down. 
Furthermore,  the  UK  appears  to  have  suffered  from  strong  competition  in  the  products  and 
destinations in which it specialises. However, as shown in Graph 22, the UK is likely to have 
faced  only  moderate  competition  from  China,  as  the  overlapping  index25  between  both 
countries  is  in  the  mid-range  when  compared  with  other  EU  economies.  Considering  a 
breakdown of the overlapping products, the categories where direct competition from China 
appears to be more relevant are in minerals, chemicals and, particularly, machines (see Graph 
23). 

Graph 21: Contribution to UK market share growth 
from geographical and sectoral composition  

2,0

0,0

-2,0

-4,0

-6,0

-8,0

-10,0

-12,0

)

%

(

y
-
o
-
y
e
g
n
a
h
c

f
o
e

t

a
R

Pre-crisis

Post-crisis

United Kingdom

Market share gains in product markets
Market share gains in geographical destinations
Initial product specialisation
Intial geographical specialisation

Source: Commission services 

25 The overlap was calculated using the Finger-Kreinin index. It is based on the number of HS 6-digit products that are exported to the rest 
of the world, and that both China and the UK export.  

24 

 
 
 
 
 
 
 
                                                            
Graph 22: Overlapping indices with China 

Graph 23: UK export products - similarity 
with China vs. share in total UK exports  

40

35

30

25

20

15

10

5

0

art

othermanuf

footwear

textile

leather

plastic

paper

pearls

wood

stone

arms
fats

)

%

i

(
g
n
p
p
a
l
r
e
v
O

80

70

60

50

40

30

20

10

0

mineral

metals

machines

optical

vegetables

food

animals

vehicles

chemical

IT

DE

NL

HU

ES

FR

SE

AT

DK

UK

BE

PT

SI

BG

FI

GR

IE

CY

MT

0

10

20

30

Export shares (%)

Source: Commission services, Comtrade 

Source: Commission services 

Rebalancing towards new geographical markets is unfolding 

In  2011,  the  EU  still  represented  approximately  half  of  the  UK  export  market,  but 
exports to new emerging markets have been rising fast since 2009. As shown in Graph 24, 
export values to the BRIC countries have more than doubled, albeit from a low base, since a 
trough  in  2009.  By  year-end  2012,  BRIC  countries  represented  approximately  8%  of  total 
goods exports. 

The dynamism of exports to BRIC countries contrasts with the slow growth of exports 
to the rest of the world over the same period. In particular, export volumes to EU countries 
in  2012  were  only  slightly  above  those  witnessed  in  2009.  This  was  due  not  only  to 
weaknesses in the euro area, but also to the slow appreciation of sterling vis-à-vis the  euro 
since mid-2011 and through the first half of 2012. 

Graph 24: UK goods exports to BRIC and 
other countries 

280

260

240

220

200

180

160

140

120

100

80

e
g
a
r
e
v
a

g
n

i
l
l

o
r
h
t
n
o
m
-
3
,
0
0
1
=
7
0
0
2

.
n
a
J

7
0

8
0

9
0

0
1

1
1

2
1

Brazil, Russia, India and China

Rest of the world

Source: ONS 

25 

 
 
 
 
 
 
 
 
 
 
 
Fast-growing  countries  present  an  important  opportunity  for  selected  British  goods. 
Exports  to  Asian  countries  have  shown  a  remarkable  dynamism  since  the  2007  crisis.  For 
instance, exports to China and Korea more than trebled during this period, although this was 
from a low starting point. Fast-growing Asian markets have shown an appetite for UK cars26, 
fashion  products  and  other  luxury  goods,  as  well  as,  to  some  extent,  capital  goods  and 
professional services, which could be further exploited.  

3.1.2.  Characteristics of the UK trading sector 

Trade in goods and services is relatively diverse, but with important specialisation areas 

The UK trades a diverse mix of goods and services (Table 2). As to the former, industries 
with  a  strong  export  propensity  in  the  UK  include  machinery  and  electrical  products, 
vehicles,  aeronautics  and  aerospace,  chemicals,  pharmaceuticals,  and  metals,  stones  and 
related products. Car exports have been particularly dynamic in recent years. The UK posted 
its  first  quarterly  car  trade  surplus  since  1976  last  year  and  approximately  eight  in  ten  cars 
produced in the UK are now exported. 

Table 2:  Top UK Exports by Category of Goods and Services (2010)

Category
Machinery / Electrical Products

Other business services

Mineral Products
Financial services
Transport Equipment

Chemicals / Related Industries

Transport

Travel

Metals / Metal Products

Stone / Glass / Ceramics

Foodstuffs

Precision Instruments

Royalties and licence fees

Plastics / Rubbers

Aerospace

Computer and information services

Insurance

Textiles

Wood / Wood Products

Other
Communications

Animal / Animal Products

Miscellaneous Manufacturing

Personal, cultural and recreational serv
Total

So urce: ITC Trade Database, o wn calculatio ns

UK Exports 
(£ Thou.)

Share of UK 
Exports

UK Share of 
World Exports

57 925 389
48 686 360
34 204 540
30 804 482
26 135 941
24 938 688
20 503 950
19 798 257
16 485 278
12 712 743
10 529 160
10 467 262
9 245 229
9 154 219
8 808 721
7 529 553
6 720 272
6 465 765
6 050 554
5 305 038
4 836 265
3 826 391
3 451 230
2 557 329
416 602 880

13.90%
11.70%
8.20%
7.40%
6.30%
6.00%
4.90%
4.70%
3.90%
3.00%
2.50%
2.50%
2.20%
2.20%
2.10%
1.80%
1.60%
1.50%
1.40%
1.30%
1.20%
0.90%
0.80%
0.60%
100%

2.40%
8.00%
2.00%
17.90%
3.10%
4.00%
4.00%
3.20%
2.30%
3.50%
3.70%
3.10%
5.80%
2.20%
6.00%
5.40%
12.30%
1.50%
2.50%
2.70%
8.90%
2.20%
1.80%
9.20%
3.40%

26  More  than  half  of  cars  exported  by  the  UK  go  to  non-EU  markets,  whereas  the  equivalent  figures  for  France,  Italy  and  Spain  range 
between 10% and 30%. 

26 

 
 
 
 
                                                            
The  trade  in  oil  balance  turned  negative  in  2005  and  is  expected  to  continue  to  drag 
down the trade balance in the future (Graphs 25 and 26). By year-end 2012, trade in oil 
contributed nearly 1 pp. to the current account deficit. Besides an on-going trend of declining 
oil production, the recent deterioration was also due to a rise in oil prices, which has further 
contributed to increase price pressures for (non-oil) UK exporters. 

Graph 25: Trade in oil balance 

Graph 26: Oil production 

P
D
G

f
o
%

1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4

-0.6

-0.8

-1.0

-1.2

OBR
forecast

Mt

140

120

100

80

60

40

20

0

90

95

00

05

10

1980

1985

1990

1995

2000

2005

2010

2015

Source: Office for National Statistics 

Source: DECC, OBR 

The financial and professional services cluster is of obvious importance to UK services' 
trade.  As  depicted  in  Graph  27,  financial,  insurance  and  business  services  constitute  the 
majority of UK service exports. Tourism and transport make up most of the remainder. 

Graph 27: Decomposition of UK service 
exports 

3h - Personal, cultural and
recreational services

3g - Other business services

3e - Computer and information

3d - Financial services

3c - Insurance

3b - Construction

3a - Communications

3 - Other services

2 - Travel

1 - Transport

0

10

20

30

40

2004

2010

% share in services exports

ource: Commission services 

The dividing lines between goods and services are increasingly blurred, which can play 
to the UK's commercial strengths. Services can complement, add value to and be bundled 
with  goods  and  other  services.  The  UK's  strengths  in  professional  services,  media, 
publishing, entertainment and in range of immaterial goods can be further exploited, not only 

27 

 
 
 
 
for  the  growth  potential  that  these  increasingly  global  markets  represent,  but  also  in 
association with other productive activities. 

UK productivity lags behind that of other leading economies 

Labour  productivity  increased  rapidly  in  the  1990s  in  the  UK,  but  remains  somewhat 
below that of France or Germany (see Graph 28). In particular, productivity growth in 
the  goods-producing  sector  lagged  behind  that  of  the  services  sector.  Whereas  the  UK 
displayed the seventh highest labour productivity growth in the EU-27 from 2000 to 2010 in 
the  services  sector,  it  ranks  sixteenth  when  the  same  measure  is  applied  to  the  industrial 
sector.27 Additionally, the evolution of total factor productivity in manufacturing from 2001 
to  2009  compares  unfavourably  to  that  of  other  EU  countries.28  While  rates  of  return  on 
employed  capital  where  similar  in  1997  in  the  services  and  manufacturing  sectors29,  they 
have since diverged and are now significantly higher in the services sector. In fact, the UK's 
structural problems set out in this review (including a restrictive planning system, high land 
and house prices, weak infrastructure and gaps in technical skills) tend to disproportionately 
hamper capital-intensive and manufacturing industries. 

Graph 28: Current price GDP per hour 
worked relative to the UK 

135

130

125

120

115

110

105

100

0
0
1
=
K
U

France

Germany

Italy

G7 exc. UK

1991

2000

2007

2011

Source: ONS 

The UK shows distinct strengths in R&D, but investment remains low 

R&D  intensity  is  lower  in  the  UK  than  on  average  across  the  EU.  In  2010,  the  UK 
invested  1.8%  of  GDP  in  R&D,  a  figure  which  is  lower  than  the  EU  average  (2.0%)  and 
which  decreased  during  the  previous  decade.  While  the  UK  has  one  of  the  highest  R&D 
investment  intensities  in  the  services  industry30,  as  well  as  one  of  the  highest  shares  of 
knowledge-intensive services in total services, R&D investment intensity in manufacturing is 
only the tenth highest in the EU. 

Nevertheless, the UK possesses important R&D assets, which can be further exploited. 
The UK is home to several world-class universities and its scientific production is among the 
most  quoted  in  the  world.  It  also  benefits  from  highly-skilled  talent,  some  of  which  it  has 

27 Data from DG ECFIN's Sectoral Performance Indicators database, which is based on public sources. 
28 See Altomonte et al (2012). 
29 See ONS (2013b). 
30 As measured by business enterprise R&D expenditure in market services as a share of the value added in market services. 

28 

 
 
 
 
                                                            
been able to attract from overseas, and is a leading researcher and developer in a number of 
sectors 
the 
commercialisation  of  research  in  the  UK  could  be  better  exploited  by  reinforcing  the  links 
between industrial and research sectors.31 

such  as  aerospace,  nanotechnology  and  pharmaceuticals.  However, 

A favourable business environment, but the planning system can raise costs for businesses 

The UK compares well to EU peers on several business environment indicators. The UK 
ranked second among EU countries, and seventh worldwide, in the 2013 edition of the World 
Bank's Doing Business report with respect to the overall "ease of doing business" indicator.  
Likewise,  the  UK  ranked  eight  out  of  144  countries  in  the  2012-13  edition  of  the  Global 
Competitiveness Report, moving up two positions compared to the previous year. Corruption 
perceptions  are  comparatively  low  according  to  Transparency  International's  corruption 
perception  index  and  the  UK  is  the  least  regulated  of  all  OECD  countries  according  to  the 
economy-wide  product  market  regulation  index.32  Nevertheless,  model-based  analysis 
suggests  that  there  is  still  scope  for  a  decrease  in  the  mark-up  of  intermediate  goods 
producers to reflect positively on the current account.33 

Planning and land use restrictions are not usually captured in standard indicators, but 
can  be  a  significant  source  of  costs  for  businesses  in  the  UK.  As  discussed  in  the  next 
section  on  debt  and  the  housing  market,  the  planning  system  and  restrictions  on  the  use  of 
land  impact  negatively  on  economic  performance  in  the  UK.  This  is  the  case  for  capital-
intensive  and  goods-producing  industries,  which  rely  more  heavily  on  land  as  a  primary 
production factor, but also for office space, which is among the most expensive in the world, 
imposing a "regulatory tax" on businesses.34  

SMEs dominate the corporate landscape in the UK, as they do in the EU generally 

SMEs constitute the vast majority of companies in the UK and in the EU, and tend to 
display  a  lower  export  propensity.  As  shown  in  graphs  29  and  30,  firm  size  is  strongly 
correlated  with  productivity  for  industrial  companies  and  with  export  propensity  more 
generally.  In  fact,  the  ability  to  compete  internationally  is  usually  reserved  for  the  most 
productive companies. It is therefore important that legislation and business frameworks do 
not  incentivise  SMEs  to  stay  small.  Overall,  the  UK  does  not  stand  out  negatively  when 
compared to EU peers in terms of market structure and number of firms by size class, and it 
is home to a significant number of large and multinational companies.  

31 European Commission (2012g) 
32 OECD (2013). 
33 See the 2012 in-depth review for the UK (European Commission, 2012e) 
34 See Cheshire et al. (2008). 

29 

 
 
                                                            
Graph 29: Number of UK firms distribution 
by firm size class 

Graph 30: UK exports by destination 

%

100

90

80

70

60

50

40

30

20

10

0

0-9

10-19

20-49

50-249

250 plus

Industry

Services

Firm size class

%

80

70

60

50

40

30

20

10

0

0-9

10-49

50-249

250 plus

EU27

ExtraEU27

Firm size class

Source: Commission services 

Source: Commission services 

Graph 31: UK labour productivity 
distribution by firm size class  

120

100

80

60

40

20

0

r
e
k
r
o
w

r
e
p
s
d
n
a
s
u
o
h
t

R
U
E

0-9

10-19

20-49

50-249

250 plus

Industry

Services

Firm size class

Source: Commission services 

Exporting  companies  in  the  UK  tend  to  be  larger  when  compared  with  EU  peers  and 
there  is  scope  for  increasing  the  number  of  exporting  SMEs.  Small  and  medium 
enterprises in the UK are more focused on the internal market and make up less of the total 
number  of  exporting  companies  than  they  do  in  Germany  or  France.  By  contrast,  the  UK 
possesses a comparatively high share of firms in the two extremes of the size distribution of 
exporting companies (approximately 60% and 15% of exporting companies in the large and 
micro category, respectively). Whereas 25% of EU SMEs exported in 2006-2008, this figure 
drops to 21% in the case of the UK.35 Therefore, helping SMEs gain a foothold in external 
markets could contribute towards boosting the UK export performance. 

35 European Commission (2010). 

30 

 
 
 
 
 
 
 
 
                                                            
The import content of exports is relatively low in the UK mainly due to the large size of its 
economy and the importance of service exports 

The  import  content  of  UK  exports  was  the  lowest  in  the  EU-27  in  2009,  standing  at 
approximately 18%, as shown in Graph 32. This means that the UK imports relatively few 
intermediate  imports  to  further  process  into  exports.  In  general,  the  extent  of  imported 
intermediate  inputs  typically  reflects  access  to  greater  input  variety  in  terms  of  quality  and 
price,  which  should  benefit  a  country's  exports.  It  also  gives  an  indication  of  how  well  a 
country is integrated in global value chains. 

Graph 32: Import content of exports (2009) 

%

70

60

50

40

30

20

10

0

LU

IE

HU

SK

CZ

BE MT

SI

DK

NL

BG

LT

EE

SE

FI

AT

PL

PT

CY

DE

FR

LV

GR

ES

RO

IT

UK

Source: WIOD, Commission services 

In the case of the UK, the low import content can be understood as a consequence of the 
large  size  of  its  economy,  the  importance  of  services  in  its  export  profile  and  its  high 
degree of energy sufficiency. Large economies tend to be less open to imports as they can 
more easily find the necessary production inputs within their economic territory. The fact that 
the  UK  is  self-sufficient  in  terms  of  energy  needs  to  a  comparatively  high  degree  also 
contributes to a lower import content of exports. Finally, service exports typically display a 
lower  import  content  and  the  UK  possesses  a  comparatively  large  share  of  services  as  a 
percentage  of  total  exports.  In  fact,  60%  of  the  value  of  UK  gross  exports  originate  from 
service  industries  according  to  the  OECD-WTO  trade  in  value  added  database,  one  of  the 
highest  figures  among  the  41  countries  in  the  dataset.  Domestic  value  added  is  particularly 
high in financial and business services, and the UK displays a significant services content in 
manufacturing  exports.  As  such,  preserving  a  dynamic  services  exporting  sector  remains 
crucial, even as the UK seeks to increase its manufactured exports.  

When considering only the import content of manufactured exports, estimations for the UK 
stood at 30% for 2005, a figure similar to that of other large EU countries such as Germany, 
France and Italy36. 

36 IMF (2011). 

31 

 
 
 
                                                            
3.1.3.  Structural challenges 

UK infrastructure struggling to meet the demands of the global economy 

Investment in the UK has remained consistently among the lowest in the EU throughout 
the years, as shown in Table 3. This is partly explained by the importance of the services and 
other less capital-intensive sectors in the UK economy, but also by the fact that government 
investment  is  particularly  low.  In  the  post-crisis  period,  UK  companies  have  also  favoured 
the  accumulation  of  surpluses  to  investment,  as  demand  remains  muted  and  uncertain,  and 
external funding is not always available for small and medium companies. Investment in the 
UK  is  tilted  towards  brand  equity,  firm  specific  human  capital  and  organisational  capital, 
with  machinery  and  equipment  representing  a  comparatively  small  share  of  total 
investment.37 

Table 3: Investment rates1 for the UK and EU 27

UK
EU 272

UK's Rank

2005
17%
23%
27

2006
18%
25%
27

2007
18%
26%
27

2008
17%
25%
27

2009
14%
19%
26

2010
15%
20%
26

2011
15%
20%
25

2008-2011 1995-2011

15%
21%
26

17%
22%
27

So urce: Euro stat, o wn calculatio ns

1) Investment rates defined as gro ss capital fo rmatio n/GDP

2) The EU 27 rate is calculated as the simple average o f the 27 EU co untries.

The UK displays important investment needs in infrastructure. According to the World 
Economic  Forum,  the  UK  currently  ranks  24th  on  quality  of  its  overall  infrastructure.  As  a 
comparison,  France  ranks  fifth  and  Germany  ninth.  Transport  infrastructure  is  of  particular 
importance  for  the  goods-producing  sector,  an  area  where  the  UK  trade  balance  is  in  a 
persistent  and  significant  deficit.  UK  producers  need  to  be  able  to  move  goods  and  factors 
around in their economic territory and to export them overseas. Around GBP 310 billion of 
investment is needed over the duration of the current parliament and beyond in energy, roads 
and network rail, according to Infrastructure UK, a unit of HM Treasury. The need to upgrade 
the  UK's  infrastructure  is  also  widely  recognised  in  business  surveys  (see  Graph  33  for  an 
example). 

Graph 33: UK infrastructure compared 
with other countries 

0

20

40

60

80

100

U
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no difference

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37 OECD (2010). 

32 

 
 
 
                                                            
Source: CBI/KPMG infrastructure survey 

Transport is a significant contributor to producer's costs. The increase in the UK's HICP 
of transport services was the highest of all Member States in the 2009-2011 period. 

The UK's motorway and rail network is one of the least dense in the EU-27 with respect 
to the number of inhabitants and airline passenger transport services display one of the 
worst  market  performance  indicators38.  The  UK's  ratio  of  average  speed  to  free-flow 
traffic  speed  is  also  one  of  the  lowest  in  the  EU39  and  research  by  the  Federation  of  Small 
Businesses suggests that the state of roads costs approximately half of small businesses up to 
GBP 5000 per year due to congestion and poor maintenance. 

Seaport capacity is of particular importance to the UK given that its ports handle the 
second highest gross weight of goods in the EU and seaports could benefit from better 
transport  connections.  Additionally,  there  is  a  growing  shortage  of  airport  capacity  in 
the south east of England, where demand is concentrated. 

Shortfalls in energy capacity are looming and some companies are reporting electricity 
shortages.  A  large  part  of  the  UK's  electricity  generation  capacity  will  require  renewal  or 
upgrading  in  the  next  decade.  According  to  a  recent  survey  by  the  British  Chambers  of 
Commerce, more than half of the surveyed companies had experienced an energy interruption 
in the last three years, with a large share of companies considering that the security of energy 
supply will be a greater issue in the future. 

The government has stated it wants to access pension funds and other private capital to 
fund  infrastructure  improvements  including  new  road  developments  and  replacing 
ageing electricity generating capacity. However, while the impact of sharp cuts to publicly-
funded  construction  and  maintenance  is  already  being  felt,  the  government's  aspirations  on 
private funding have not yet generated results. In the Autumn Statement 201240, a successor 
initiative was also announced to the private finance initiative (PFI) – this will be called PFI 2. 
The  government  announced  a  GBP  40  billion  infrastructure  guarantee  fund  to  assist  large 
infrastructure  projects  that  are  currently  struggling  due  to  adverse  credit  conditions.  The 
projects  can  come  from  a  range  of  sectors  including  transport,  energy,  utilities  and 
communications, and must satisfy a number of criteria. The scheme has received 75 enquiries 
from project sponsors to date, of which projects with a capital value of around GBP 10 billion 
have been prequalified as eligible for consideration of a guarantee. On 29 November 2012 the 
UK  Government  proposed  a  new  energy  bill,  putting  in  place  measures  to  attract  the  GBP 
110  billion  investment  which  is  needed  to  replace  the  current  generating  capacity  and 
upgrade the grid by 2020, and to cope with a rising demand for electricity. 

Most  of  the  government's  plans  for  increasing  private  investment  remain  aspirational 
and  the  UK  needs  to  be  careful  not  to  repeat  the  mistakes  of  past  PFI  projects.  Audit 
evidence  suggests  the  previous  PFI  model  was  a  costly  way  of  procuring  public 
infrastructure,  largely  because  long  term  projects  were  funded  at  a  (higher)  private  rate  of 
return  than  the  cost  of  public  borrowing.  There  has  been  a  lot  of  uncertainty  over  the 
prospects for energy investment due, in significant part, to regulatory risks.  

38 European Commission (2012c). 
39 European Commission (2012c). 
40 HM Treasury (2012). 

33 

 
 
                                                            
Skill gaps affect labour productivity, in particular in manufacturing sectors 

Evidence  suggests  that  UK  producers  are  confronted  with  a  significant  skills  gap, 
namely  in  manufacturing,  where  the  required  intermediate  technical  skills  are  not 
always available. A recent survey of manufacturers cited lack of technical skills as the single 
most  important  reason  for  recruitment  problems.41  In  fact,  recruitment  difficulties  in  the 
manufacturing  sector  have  continued  to  rise  in  2012  as  shown  in  Graph  34,  even  as  the 
overall economy has struggled. This, in turn, has contributed to hinder the rebalancing of the 
economy towards the goods-producing tradable sector.  

Graph 34: Recruitment difficulties 

i

g
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r
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75

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45

40

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p
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S

Manufacturing

Services

Source: The British Chambers of Commerce 

Skills mismatches in the UK are mostly of a vertical nature, whereby a significant share 
of  the  population  does  not  possess  the  appropriate  level  of  education.  According  to  a 
recent  study,  more  than  40%  of  employees  are  either  over-  or  under-qualified  (see 
Graph  35).  The  large  share  of  under-qualified  personnel  is  a  reflection  of  the  insufficient 
number of workers with intermediate 'vocational' training. Conversely, a non-negligible share 
of the workforce is deemed to be over-qualified. This is linked to the government and social 
focus  on  university  education,  which  may  lead  to  its  overvaluation  vis-à-vis  the  technical 
skills  demanded  by  some  sectors  of  the  labour  market.  By  contrast,  the  UK  displays  a 
comparatively low level of horizontal mismatches meaning that, given the educational level, 
the fields of study are broadly appropriate (Graph 36). Nevertheless, insufficient knowledge 
of  foreign  languages  may  constrain  the  ability  of  companies  to  conduct  business  in  foreign 
markets.  According to  a recent survey42,  the  overwhelming  majority  of  business  owners  do 
not  possess  the  necessary  language  skills  to  conduct  business  in  the  buyers'  language,  with 
52% of respondents claiming that language barriers are either highly or somewhat influential 
when deciding if, when and where to export. 

41 EEF and JAM (2012) 
42 British Chambers of Commerce (2012a) 

34 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                                            
Graph 35: Average incidence of vertical mismatch (2001-2011) 
in EU-27 countries, % of employees (aged 25-64) 

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

SK CZ RO SI PL HU BG LU FI DK PT DE AT SE LV EE MT IT LT UK CY NL FR GR BE ES IE

Over-qualification

Under-qualification

Matched qualification

Source: Commission services 

Graph 36: Incidence of horizontal mismatch in Europe, % of 
employed, 2009, EU-27 

45

40

35

30

25

20

15

10

5

0

IE

ES GR UK IT

LU BE

FI

EU DE NL SE AU LV EE RO FR DK HU SI CY BG LT CZ

SK PL

Source: Commission services, Randstat 

More restrictive immigration policies may affect the UK's ability to compete for global 
talent. According to the Office for National Statistics, net migration to the UK decreased by 
one quarter in 2012. This was partly due to more people leaving the country, but also due to 
20,000 fewer overseas students entering the country. The UK authorities have made it more 
difficult for graduates to work in the UK, affecting the UK higher education industry, which 
has  a  significant  export  propensity.  Additionally,  the  fact  that  visa  applications  may  take  a 
long time to be processed and that allocations are not fully used may hamper the UK's ability 
to attract globally-mobile talent. 

A number of initiatives are underway to improve skills and reform the educational offer 
in  the  UK,  among  them  the  national  apprenticeships  programme.  The  number  of 
apprenticeship starts in 2011-2012 was 520,600, up from 457,200 in the previous academic 
year. It is crucial that apprenticeships deliver high quality training to participants and that the 

35 

 
 
 
 
 
technical  and  professional  skills  so  developed  be  properly  assessed.43  A  review  of  the 
national curriculum in England is also currently underway and new programmes of study are 
planned to be introduced in 2014. In Scotland, the new curriculum for schools from age 3-18 
is  gradually  being  implemented  and  in  Wales  the  National  Literacy  and  Numeracy 
Framework sets out annual expected outcomes in literacy and numeracy since 2012. Overall, 
it is important that reforms to the educational system be demand- rather than supply-led, in 
the sense that they be able to address skill shortages in the UK's workforce going forward. 

Difficulties accessing finance constrain entry into and expansion of the exporting sector 

An  important  share  of  SMEs,  including  younger  and  innovative  companies,  remains 
credit constrained. Although the UK compares favourably with the EU peers on indicators 
measuring  availability  and  ease  of  access  to  venture  capital,  access  to  credit  by  UK  SMEs 
was  severely  affected  by  the  financial  crisis.  A  composite  indicator  derived  from  the 
ECB/European Commission surveys on SME access to finance44 shows that access to bank 
loans by SMEs in the UK deteriorated markedly in the post-crisis period (see Graph 37). In 
fact, during this period, most surveys of SME access to finance in the UK put loan rejection 
rates between one fifth and one third of total applications.45 

Graph 37: Index of SME access to bank loans 

2009

2011

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0

FI

LV SE PL AT DE SK BE CZ MT LT CY BG DK RO LU EU IT EE FR NL HU UK ES SI PT IE EL

Source: ECB, Commission services 
Note: the index was constructed based on responses to six questions on SME perceptions 
and experience from the ECB/Commission surveys on access to finance; the index ranges 
from zero (worst possible situation) to one (best possible situation). 

Following the 2008-2009 depreciation, the UK exporting sector became more attractive, 
with many of the current exporters opting to increase their margins. Promoting access to 
finance  for  current  and  potential  exporters  can  help  tilt  the  positive  effects  of  depreciation 
from an increase in export prices to an increase in export quantities. This is especially true for 
younger companies, which often struggle to obtain credit according to survey evidence.  

Access  to  trade  finance  and  trade  credit  is  particularly  important  at  the  current 
juncture. Following the financial crisis and as a consequence of deleveraging efforts by the 
banking  sector,  some  banks  exited  the  market  for  exporter-specific  financing  instruments. 
The UK authorities have devised specific measures that cater for the financing needs of the 
exporting sector. These include a lending facility to provide up to GBP 1.5 billion in loans to 

43 See Richard (2012). 
44 See European Central Bank and European Commission (2009, 2011). 
45 For a recent survey see Federation of Small Businesses (2012). 

36 

 
 
 
                                                            
foreign  importers  acquiring  capital  goods  and  services  from  UK  exporters,  a  supply  chain 
finance  scheme  whereby  banks  extend  supply  chain  credit  at  favourable  rates  to  SMEs  in 
deals involving large companies, and an export marketing research scheme offering support 
and funding to companies searching export markets. 

3.1.4.  Conclusions 

UK  trade  and  external  competitiveness  demonstrates  a  noticeable  underperformance. 
The  current  account  has  been  in  a  persistent,  albeit  moderate,  deficit  since  1997  and 
important losses in international market shares have accumulated during the 2000s. The trade 
in  goods  balance  has  been  locked  in  negative  territory  for  decades,  although  this  has  been 
partly compensated for by trade surpluses stemming from the more dynamic services sector, 
and by foreign income flows. 

The factors explaining the external dynamics of the UK economy are multifaceted, with 
no  single  dominant  reason  accounting  for  the  suboptimal  performance  of  the  UK 
external  sector.  These  factors  are  both  circumstantial  and  structural.  Among  the 
circumstantial and cyclical factors impacting the UK's competitiveness in recent years are a 
decade-long  of  strong  currency  which  lasted  until  2007  and  which  has  since  reversed,  a 
temporary collapse in foreign demand in the wake of the crisis that affected sectors in which 
the UK is specialised such as financial and professional services, and strong unit labour cost 
dynamics,  which  were  driven  by  high  inflation  (part  of  which  is  imported)  and  a  drop  in 
labour productivity (part of which is likely to be cyclical).46 

In  2012,  in  particular,  the  UK  current  account  suffered  from  weak  demand  from 
traditional European markets, depressed foreign income inflows and a deterioration in 
the oil trade balance. The UK trade performance has also been affected by more lasting and 
structural burdens. Traditional UK export markets have remained focused on slower-growing 
developed economies, although the exporters continued to rebalance towards new geographic 
destinations in 2012. Additionally, overall labour productivity in the UK lags behind that of 
other  leading  economies.  This  is  noticeably  the  case  in  manufacturing,  where  productivity 
growth  has  been  sluggish.  Also,  the  UK  is  becoming  increasingly  confronted  by  the 
dwindling production levels of the North Sea oil fields. 

A number of structural constraints lend themselves to appropriate policy intervention. 
Foremost  among  these  are  infrastructure  inadequacies,  a  technical  and  intermediate 
skills  gap  and  problems  in  accessing  finance.  Higher  investment  in  infrastructure  would 
crucially  support  businesses  in  circulating  goods,  inputs  and  production  factors  in  the  UK, 
and  exporting  products  overseas.  Narrowing  the  existing  gap  in  intermediate  and  technical 
skills  would  foster  higher  productivity  and  expansion  of  the  manufacturing  sector.  Finally, 
easing access to finance could help new companies enter the exporting sector and facilitate 
the expansion of current exporters. 

The  UK  authorities  have  sought  to  address  these  constraints  through  a  diverse  set  of 
policy  measures.  Investment  in  infrastructure  is  being  increased,  but  only  after  capital 
spending slashes in 2010 and 2011. The apprenticeships programme can help close skill gaps, 
but  the  quality  of  training  provided  should  be  carefully  monitored.  Access  to  finance 
initiatives  have  been  supportive  of  the  flow  of  credit  and  funding  to  the  real  economy  but 

46 For a complementary assessment of competitiveness developments in the pre-crisis and the initial post-crisis years including issues not 
dealt at length in this review see the 2012 in-depth review of the UK economy (European Commission, 2012e). 

37 

 
 
 
                                                            
have not been able to normalise it, which, on current policies, may not happen until growth 
and more favourable macroeconomic conditions have been fully re-established. 

Despite  some  non-negligible  weaknesses,  the  competitiveness  of  the  UK  economy 
benefits  from  notable  strengths.  The  UK  offers  a  business-friendly  environment  and  its 
economy  is  comparatively  flexible  with  respect  to  both  product  and  labour  markets.  The 
quality of the UK science base is recognised worldwide, although commercial appropriation 
of research can be improved. The UK industrial fabric includes global leaders in the services 
sectors as well as in medium- and high-tech goods-producing sectors, the car industry being a 
good case in point in 2012. 

Although  the  persistence  of  an  external  competitiveness  underperformance  constitutes 
an  imbalance  in  the  UK  economy,  a  degree  of  rebalancing  towards  net  exports  has 
taken place since the outset of the crisis. Export volumes have grown 3.3% between 2007 
and 2011, a time when overall GDP contracted. With no important medium-term threats from 
an external sustainability point of view, the external dimension of the UK economy has not 
been an important source of macroeconomic instability, but neither has it delivered so far on 
its full potential as an engine of growth. 

38 

 
 
 
 
3.2. 

Private debt, deleveraging and growth 

This section analyses the distribution and dynamics of corporate and household debt in turn, 
and  how  current  government  policy  and  macroeconomic  conditions  are  affecting  them.  It 
then  assesses  the  potential  paths  of  private  debt  stocks,  flows  and  servicing  costs,  and  the 
extent to which they are a potential source of macroeconomic instability or persistently weak 
growth. 

3.2.1.  Corporate debt and access to finance  

Though total  non-financial corporation  (NFC)  debt is on  the high side, firms  are saving in 
aggregate and some are cash-rich 

As discussed in Section 2.5 and shown in Graph 38, the leverage of UK NFCs increased 
in the pre-crisis period and corporate debt remains above the EU average, despite some 
deleveraging  since  2008.  In  common  with  firms  across  the  EU,  UK  businesses  steadily 
increased  their  total  borrowing  in  the  decade  before  the  crisis,  encouraged  by  benign 
macroeconomic conditions and easy availability of credit. The corporate debt-to-equity ratio 
increased  rapidly  in  the  early  2000s,  due  to  a  fall  in  the  UK  stock  market  following  the 
bursting  of  the  international  dot-com  bubble,  then  stabilised  until  the  crisis.  However,  the 
increase  in  debt-to-equity  did  not  lead  to  a  period  of  deleveraging  as  wider  economic 
conditions  remained  favourable.  In  the  run  up  to  the  financial  crisis  banks  continued  to  be 
willing to lend and companies to take on additional debt. Debt-to-equity spiked in 2008 due 
to temporary valuation effects from a drop in the stock market. In contrast, the NFC debt-to-
financial-assets ratio has remained broadly stable since 1995, as financial assets have grown 
at  a  similar  rate  to  debt.  Note  that,  as  discussed  below,  the  assets  and  liabilities  are  not 
necessarily in the same firms and sectors. 

Graph 38: Indicators of leverage in non-
financial corporations 

s
t
e
s
s
a

l

a

t
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d
n
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P
D
G

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%

(

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140

120

100

80

60

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0

5
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1

*
2
1

Debt / GDP

Debt / assets

Debt / equity

Debt / assets, consolidated  

Source: Commission services 

As Graph 39 shows, in aggregate UK NFCs remained profitable before and during the 
crisis,  with  a  higher  share  of  retained  earnings than the  euro area  average every year 
since  2003.  A  combination  of  continued  profitability  and  low  investment  has  led  to 
NFCs  being  net  lenders  since  2002,  as  seen  in  Graph  40.  Since  the  onset  of  the  crisis, 
when  business  investment  fell  sharply  but  profits  held  up  relatively  well  in  a  context  of 
39 

 
 
 
 
 
 
 
 
 
 
 
 
falling  real  wages,  net  lending  of  NFCs  has  increased  further.  UK  NFCs  as  a  whole  have 
consequently accumulated significant surpluses, as many businesses are wary of investing in 
face  of  a  subdued  and  volatile  demand.  Additionally,  a  large  fraction  of  smaller  businesses 
have  had  to  build  up  internal  funding  buffers  due  to  difficulties  accessing  credit  and  some 
companies have been faced with the need to save to recapitalise pension funds. For example, 
while the fall in interest rates is favourable for firms wanting to borrow, it has created a hole 
in the finances of companies with defined benefit pension schemes. A recent call for evidence 
from the UK Department for Work and Pensions47 concerns the tension between the need to 
ensure that pension fund deficits are addressed in a timely manner, and the potential negative 
impact  on  investment  and  macroeconomic  stability  if  firms  are  required  to  make  good  any 
shortfalls resulting from asset price movements too quickly. 

Graph 39: Profitability of non-financial 
corporations48 

Graph 40: Savings and investment by non-
financial corporations 

50

45

40

35

30

25

20

15

10

5

0

d
e
d
d
a
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l

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95

97

99

01

03

05

07

09

11

Gross entrepreneurial income
Gross operating surplus
Retained earnings (right axis)
Retained earnings, EA17 (right axis)

25

20

15

10

5

0

d
e
d
d
a
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d
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%

25

20

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10

5

0

-5

95

97

99

01

03

05

07

09

11

Net lending/borrowing, Non-financial Corporations
Gross savings
Gross capital formation

Source: Commission services 

Source: Commission services 

The  aggregate  picture  masks  significant  variation  across  sectors  and  firms,  which  has 
significant implications for stability and growth. The NFC profit and savings figures have 
in  part  been  flattered  by  a  high  oil  price  driving  large  profits  in  the  oil  and  gas  extraction 
sector, much of which is in the hands of companies who do not necessarily invest specifically 
in the UK. Additionally, the balance sheets of companies in sectors that have been hardest hit 
by the crisis, including real estate and construction, are not as robust. In addition to the boom 
in loans for residential property, discussed in Section 3.2.2., there was also a pre-crisis boom 
in loans to commercial property companies, much of which went to push up prices rather than 
supply.49 

Banks and firms have been focused more on securing stability than expanding lending 

The  unconsolidated  debt  of  UK  financial  corporations  is  exceptionally  high,  reflecting 
the large size and high degree of integration of the UK financial sector, including in its 
role as a global financial hub. The unconsolidated debt of the financial sector amounted to 
410%  by  end-year  2011.50  After  a  period  of  turmoil  in  the  wake  of  the  2008  crisis,  which 

47 Department for Work and Pensions (2013). 
48  Gross  operating  surplus  captures  the  excess  of  production  over  intermediate  costs  and  compensation  of  employees  (it  includes  also 
remuneration of capital for SMEs). Gross entrepreneurial income adds net interests and dividend received. Retained earnings correspond to 
the savings of non-financial corporations. 
49 See Broadbent (2012). 
50 Financial sector debt is considered separately from the concept of private sector debt in this Review and in the scoreboard indicator. 

40 

 
 
 
 
 
 
 
 
 
 
 
                                                            
required  large  government  interventions  to  guarantee  the  liquidity  and  solvency  of  several 
UK banks, the banking sector has stabilised. 

The balance sheets of UK banks have been expanding slowly in the last couple of years, 
after  the  rapid  growth  witnessed  in  the  pre-crisis  period.  Overall,  the  banking  sector 
appears to have returned to relative stability, as reflected in a number of indicators. Capital 
ratios  have  strengthened  significantly  since  2008  and  UK  banks  are  now  among  the  best 
capitalised  in  the  EU.  CDS  and  senior  unsecured  bond  spreads  remain  contained  and  have 
been narrowing since 2011. Finally, the UK banking sector shows a low exposure to public 
debt of countries under market stress, although the exposure to private debtors, especially in 
Ireland and Spain, is more significant. However, banks may not be appropriately provisioning 
for  the  expected  losses  that  may  arise  from  their  loan  books  in  the  future.  The  interim 
Financial  Policy  Committee  (FPC)51    judges  that  banks  are  overstating  their  true  capital 
adequacy and have recommended that the Financial Services Authority (FSA) takes action to 
ensure that the capital of UK banks and building societies reflects a proper valuation of their 
assets, a realistic assessment of future conduct costs and prudent calculation of risk weights.  

Banks' loan-to-deposit ratio has fallen sharply since 2007, from 65% in 2007 to 57% in 
2011,  as  shown  in  Graph  41.  This  will  help  secure  financial  sector  stability  but  significant 
further  shrinkage  of  banks'  loan  books  through  tight  restrictions  on  new  credit  could  hold 
back the recovery of the wider economy. 

Graph 41: Financial corporations' liabilities 
and loan to deposit ratio 

50

40

30

20

10

0

-10

-20

)

%

(

y
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96

98

00

02

04

06

08

10

12*

Liabilities growth, Financial Corporations
Loans / deposits, Financial Corporations (right axis)

Source: Commission services 

The  credit  crunch  observed  in  the  UK  since  the  onset  of  the  crisis  has  resulted  from 
negative  shocks  in  both  credit  demand  and  credit  supply.  Credit  demand  has  decreased 
due  to  fewer  investment  opportunities,  higher  perceived  risk,  poorer  collateral  and  less 
appetite  to  leverage  up  in  an  uncertain  environment.  Several  reasons  may  explain  the 
contraction in credit supply including a higher perceived risk of lending in a weak economy, 
higher risk aversion by banks, a more demanding regulatory environment, a need to rebuild 
balance sheets and insufficient competition among credit providers. 

51 Financial Policy Committee (2012). 

41 

 
 
 
 
 
 
 
 
 
 
                                                            
Monetary policy remains very loose but lending is still low 

The  Bank  of  England  has  continued  its  loose  monetary  policy,  with  the  base  rate 
remaining at a low 0.5%, the quantitative easing programme being expanded by GBP 
50 billion to GDP 375 billion in July 2012, the Extended Collateral Term Repo Facility 
being activated in June 2012 and the Funding for Lending Scheme (FLS) being opened 
in  August  2012.  The  monetary  policy  measures  undertaken  by  the  Bank  of  England52  are 
positive  for  the  economy  overall  but  may  not  in  themselves  be  sufficient  to  re-establish 
lending  in  an  economy  where  the  monetary  transmission  mechanism  and  money-to-loan 
transformation ratios have been weakened. 

Net bank lending is still falling for both large firms and SMEs, and total net funding to 
UK NFCs also remains negative. As Graph 42 shows, a return to positive net issuance of 
corporate  bonds  and  commercial  paper  in  2011 and  2012  does  not  fully  offset  negative  net 
loan and equity issuance. On one hand some larger firms are using their access to cheap bond 
finance  to  undertake  significant  share  buy  backs.  In  fact,  debt  financing  may  have  become 
more  attractive  than  equity  issuance  for  some  managers  as  the  stock  market  remains 
comparatively  depressed.  On  the  other  hand  many  smaller  firms  remain  credit  constrained 
and  often  do  not  have  access  to  sources  of  funding  for  investment  other  than  retained 
earnings. 

Graph 42: Net funds raised by UK 
businesses 

n
b
P
B
G

120

100

80

60

40

20

0

-20

-40

-60

-80

03

04

05

06

07

08

09

10

11

12

Commercial paper
Equity
Total

Bonds
Loans

Source: Bank of England. 
Note: Data for 2012 are up to and including November. 

Credit availability show signs of improving  for some firms and households, but this is 
only starting to translate into lower costs and a higher volume of lending. The Bank of 
England's  Credit  Survey  found  that  the  overall  availability  of  credit  to  the  corporate  sector 
increased significantly in the last quarter of 2012. Both an improvement in external economic 
conditions  and  credit  easing  policies  appear  to  have  contributed  to  this  trend.  However, 
demand  for  credit  remained  muted  and  major  UK  lenders  report  that  a  lack  of  confidence 
among  firms  is  still  weighing  down  on  the  demand  for  credit.  The  cost  of  credit  has  fallen 
slightly for SMEs in recent months (see Graph 43) but remains above 2009 levels. Similarly 
while  the  reported  availability  of  credit  has  improved  across  the  board,  as  shown  in  Graph 
44]there has been least improvement for small businesses.  

52 In partnership with HM Treasury in the case of the FLS. 

42 

 
 
 
                                                            
Graph 43: Indicative median interest rates 
on new SME variable rate loan facilities 

Graph 44: Availability and demand for 
credit by firm size 

%

6

5

4

3

2

1

0

8
0
v
o
N

9
0
y
a
M

9
0
v
o
N

0
1
y
a
M

0
1
v
o
N

1
1
y
a
M

1
1
v
o
N

2
1
y
a
M

2
1
v
o
N

Smaller SMEs
All SMEs

Medium SMEs
Bank rate

25

20

15

10

5

0

-5

-10

-15

-20

-25

l

s
e
c
n
a
a
b
e
g
a
t
n
e
c
r
e
p
t
e
N

Small businesses

Medium PNFCs

Large PNFCs

Reported
change

Expected
change

Reported
change

Expected
change

Availability

Demand

Source: BIS, Bank of England and BoE calculations 

Source: Commission services 

Access to finance policies aim to boost credit to firms 

In June 2012, the government and the Bank of England announced the FLS to provide 
cheap  funding  for  banks  in  order  to  boost  lending  to  the  real  economy.  Banks  and 
building  societies  that  increase  lending  to  UK  households  and  businesses  will  be  able  to 
borrow at lower cost than banks that scale back on lending. Participating banks and building 
societies  will  be  able  to  borrow  up  to  5%  of  their  stock  of  existing  lending  to  the  real 
economy, plus any net expansion of lending during a reference period (from end-June 2012 
to end-December 2013). There is no upper limit on the size of either individual or aggregate 
borrowing under the scheme. Banks will be able to borrow under the FLS until 31 January 
2014 by pledging their household and NFC loan books as collateral. According to the second 
data release53 and to the list of participating institutions published as of March 2013, 39 banks 
and  building  societies  representing  more  than  80%  of  the  lending  stock  to  households  and 
NFCs  have  signed  up  for  the  FLS.  Of  these,  13  banks  and  building  societies  had  used  the 
scheme  by  the  end  of  2012,  representing  a  total  of  GBP  13.83  billion  in  outstanding 
drawings.  While  the  39  participating  institutions  registered  a  small  decrease  in  net  lending 
during the first two quarters of operation of the scheme, it is still early to measure the effects 
of the FLS as they continue to pass through to the real economy. The funding costs of UK 
banks have fallen more sharply than those of EU peers since the FLS was launched in July 
2012,  likely  reflecting  the  effects  of  the  scheme  but  also  improved  sentiment  in  global 
financial markets.54 Lower funding costs should facilitate a gradual easing in domestic credit 
conditions  which  may  explain  why  respondents  to  a  recent  Bank  of  England  survey55 
expected that the availability of credit to all sectors would increase further in the first quarter 
of 2013. While the scheme has likely contributed to increased mortgage lending, it has been 
less successful so far in boosting corporate lending, in particular to SMEs. It is possible that 
even  if  the  FLS  has  some  positive  impact,  it  may  only  succeed  in  arresting  the  decline  in 
lending to SMEs, rather than reversing it. 

53 4 March 2013. 
54 Bank of England (2013c). 
55 Bank of England, (2013a). 

43 

 
 
 
 
 
 
 
 
 
 
 
 
 
                                                            
The FLS builds on a range of other access to finance policies. The government will invest 
GBP 1 billion in a new "British Business Bank" to support the provision of long-term loans to 
SMEs via existing financial institutions. Plans for the Business Bank are under development 
but one element will be providing co-financing for the private sector to invest in sources of 
finance  that  help  diversify  the  business  finance  market.  If  properly  designed  and 
implemented, the Business Bank could make some contribution to increased competition in 
the banking industry. The National Loan Guarantee Scheme has been underway since March 
2012 to reduce  the costs  of bank loans and to promote lending to businesses.  According to 
HM Treasury, GBP 2.5 billion in cheaper loans have been offered to over 16,000 businesses 
so far. 

Both banking competition and access to non-bank finance are narrow  

Access to non-bank lending remains largely restricted to bigger firms. UK bond markets 
are  comparatively  well-developed  for  large  companies,  which  rely  more  strongly  on 
wholesale  debt  markets  than  their  counterparts  in  many  other  EU  countries.  In  the  UK,  in 
common  with  most  of  Europe,  other  firms  primarily  finance  investment  through  a 
combination  of  retained  earnings  and  bank  loans.  When  the  availability  of  bank  loans 
dropped sharply in the crisis this consequently had a greater impact on smaller firms, while 
larger  firms  were  able  to  mitigate  the  effects  of  the  credit  crunch  by  temporarily  becoming 
more reliant on other forms of finance. In the US, a wider range of firms use equity or the 
capital markets directly, allowing them to bypass an impaired banking system. The Breedon 
Task Force, commissioned by the government to inquire into alternatives to bank funding for 
businesses, estimated a substantial ongoing financing gap over the next five years, especially 
for  SMEs.  The  government  welcomed  the  report's  conclusions  and  a  number  of  related 
initiatives are being considered or implemented.56 

Competition in the banking sector is also limited, which is more of a problem for SMEs. 
Evidence suggests that competition in UK retail banking markets is low, with concentration 
levels rising markedly in the wake of the financial crisis as the assets of distressed banks were 
taken over by the government or rival banks. The government is attempting to help increase 
competition in the banking sector through the divestiture of part of the branch networks and 
loan  books  of  large  incumbent  retail  banks  to  challenger  banks.  The  government  is  also 
working with the banking industry to reduce switching costs for bank accounts. 

The  tension  between  corporate  deleveraging  and  access  to  credit  is  as  much  of  a  growth 
concern as a stability one in the short term, but risks from a high debt stock remain 

The  stock  of  UK  corporate  debt  is  relatively  high,  but  in  the  short  term  tight  credit 
conditions are as much of a problem as excessive debt. If banks are seeking to reduce their 
balance sheets but hesitating to recognise losses from a potentially stale stock of debt, it could 
both  store  up  risks  to  financial  stability  and  prevent  credit  from  being  reallocated  to  more 
dynamic and productive sectors of the economy. A fine balance has to be struck in order to 
reconcile the longer term benefits of "creative destruction", and the shorter term advantages 
of low insolvency rates supporting employment in a weak domestic economy. There is also a 
tension between the need for a sound banking system and the need to increase credit flows to 
fund investment. 

56 Department for Business, Innovation and Skills (2012b).  

44 

 
 
 
                                                            
3.2.2.  Housing policy and household debt  

The 2012 in-depth review of the UK concluded that high household debt constitutes an 
internal imbalance in the UK economy. As discussed in Section 2.5, household debt grew 
unsustainably in the boom years preceding the crisis. Commission services' analysis suggests 
that  between  2002  and  2007  the  cumulative  increase  in  UK  household  debt  above  the 
sustainable path was 26pps. of GDP. Since 2008 real household debt, which is mainly in the 
form  of  mortgages,  has  been  falling  gradually  as  mortgage  issuance  has  remained  at 
unusually  low  levels  (nominal  household  debt  has  been  broadly  flat).  Debt  secured  on  a 
mortgage  was  almost  86%  of  total  household  debt  at  the  end  of  June  2012.57  Given  that 
household debt levels remain high, there is a continuing need for deleveraging. There is also 
a  challenge  to  successfully  reform  the  planning  system  and  housing  market  so  that  they 
deliver  the  housing  supply  the  population  needs  and  are  not  a  source  of  macroeconomic 
instability.  However,  as  discussed  below,  it  is  not  clear  that  UK  household  debt  is  set  to 
continue falling as a share of GDP into the medium term. 

House prices remain high relative to incomes and historical averages, supported by supply 
fundamentals 

Real UK house prices have fallen by 17% since 2007, but average nominal house prices 
have stayed relatively flat through 2011 and 2012.58 The high level of UK household debt 
has been driven by house prices, which are still elevated relative to incomes. Despite the fall 
in real  house  prices since  2007, prices remain high and affordability is stretched. Graph 45 
shows that, given that the UK experienced among the largest house price increases in the EU 
in  the  last  upswing,  the  fall  in  real  house  prices  since  then  has  been  relatively  modest.  In 
many  other  member  states  prices  have  fallen  further  towards  the  previous  trough  which  is 
represented  by  the  red  line.  A  combination  of  high  inflation,  low  wage  growth,  high 
unemployment  and  tax-benefit  changes  has  also  squeezed  the  disposable  incomes  of  UK 
households.  Consequently,  as  Graph  46  shows,  the  price  of  housing  relative  to  income 
remains  well  above  its  long-term  average.  As  discussed  elsewhere  in  this  paper,  severe 
supply constraints are underpinning UK house prices. Due to planning restrictions the price 
of land with permission for residential development is very high.59 The UK was unusual but 
not unique in seeing a house price boom without a supply response.60  

57 Bank of England. 
58 Office for National Statistics (2012a). 
59 Hilber and Vermeulen (2012). 
60 See Broadbent (2012).    

45 

 
 
                                                            
Graph 45: UK house price cycle compared 
to other EU Member States61 

Graph 46: UK price to income ratio, 
2006=100 

Change from trough to peak (%)

FI

LU

BE

50

100

IT

SE

200

150

FR

250

300

350

DE

0

AT

PT

CZ
EL

MT

SI

SK

PL

HU

ES

NL
UK

DK

BG

EE

IE

RO

LV

Previous 
trough

)

%

(

a
t
a
d
t
s
e
t
a

l

o
t

k
a
e
p
m
o
r
f

e
g
n
a
h
C

10

0

-10

-20

-30

-40

-50

-60

-70

-80

Source: Commission services, ECB, OECD, BIS. 

Source: OECD 

However,  the  aggregate  picture  on  UK  house  price  trends  masks  important  regional 
variations.  House  prices  have  tended  to  recover  most  in  cities  and  regions  with  stronger 
economies,  growing  populations  and  the  most  severe  housing  shortages.62  For  example, 
nominal  house  prices  in  London  are  approximately  20%  above  their  pre-crisis  peak.  The 
prices of prime residential property have been especially strong, driven in part by the weak 
pound  and  safe  haven  capital  flows.  In  contrast,  house  prices  and  levels  of  housing 
transactions  in  many  poorer  regions  remain  depressed.  This  has  exacerbated  existing  house 
price  differentials  and  could  both  block  labour  migration  to  areas  of  relatively  high  labour 
demand  and  mean  that  problems  associated  with  negative  equity  become  concentrated 
primarily in poorer parts of the country. 

Planning reform has been enacted but construction remains weak and the longer term impact 
is uncertain 

A  new  spatial  planning  system  that  aims  to  create  a  presumption  in  favour  of 
sustainable development and simplify the planning system is now largely in place, but it 
has not fully bedded down yet. In addition to the new National Planning Policy Framework 
(NPPF),  there  will  be  a  major  infrastructure  fast  track  procedure  to  facilitate  planning 
applications  for  big  projects.  The  measures  announced  in  the  2011  Housing  Strategy  for 
England63  are  also  being  implemented,  which  include  freeing  up  public  sector  land  and 
various financial incentives such as the New Homes Bonus, Community Infrastructure Levy, 
Growing  Places  fund  and  a  'Get  Britain  Building'  investment  fund.  The  government  also 
recently  announced  the  liberalisation  of  planning  rules  to  allow  offices,  which  have  high 
vacancy rates in much of the country, to be converted into residential use. 

Housing  completions  remain  at  historic  lows  and  the  level  of  new  mortgage  loans 
continues  to  be  held  back  by  a  weak  domestic  economy,  impaired  credit  markets  and 
policy uncertainty and constraints. As Graph 47 shows, residential investment remains low 
at 3.2% of GDP and building permits are still only running at approximately half the level of 

61 The cumulated real house price growth from the latest trough to the latest peak is plotted against the adjustment from the latest peak to the 
latest  data  available  (Q2-2012  in  this  case).  Some  countries  for  which  the  house  price  time  series  are  too  short  and  thus  do  not  allow  to 
identify the trough are excluded.  
62 Centre for Cities (2013). 
63 HM Government (2011). 

46 

 
 
 
 
 
 
 
 
                                                            
2005  and  Graph  48  shows  that  the  UK  suffers  from  a  structurally  low  level  of  residential 
investment  compared  to  its  European  neighbours.  Overall  construction  output  (not  just 
residential)  fell  by  11.2%  in  the  year  to  2012  Q3  and  is  over  18%  lower  than  the  pre-
recession  peak.64  The  low  level  of  residential  investment  compared  to  the  EU  average  is 
particularly  notable  given  the  UK's  relatively  high  rate  of  population  growth  and  new 
household  formation.  According  to  the  UK's  Office  for  National  Statistics  (ONS),  in  2012 
there  were  62.2  million  people  living  in  Britain,  this  is  expected  to  reach  71.4  million  by 
2030. Official long term forecasts are for the number of households in England alone to rise 
by  232,000  per  year.65  This  is  well  above  the  146,000  dwellings  completed  in  the  UK  in 
2011-12.  Linked  to  the  high  cost  of  land,  new  dwellings  in  the  UK  are  also  small,  even  in 
comparison  to  other  densely  populated  countries.  A  new-build  house  is  38%  smaller  in  the 
UK  than  in  Germany  and  40%  smaller  than  in  the  Netherlands.66  This  exacerbates  the 
shortage of living space. 

Graph 47: Residential investment and 
building permits67 

Graph 48: Residential investment,         

% GDP 

0
0
1
=
5
0
0
2

120

100

80

60

40

20

0

95

97

99

01

03

05

07

09

11

Building Permits (2005=100)

Residential Investment (% of GDP, right axis)

14

12

10

8

6

4

2

0

P
D
G

f
o
%

5

4

3

2

1

0

IE

ES

SE

DK

FI

NL

UK

DE

2002Q2

2007Q2

2012Q2

Source: Commission services 

Source: EMF, ECB, Commission services 

It is also not yet clear how far the reforms that the government has so far delivered or 
promised  will  have  the  desired  positive  effect  on  housing  supply.  Some  of  the 
government's  reforms  first  caused  further  reductions  in  housing  supply.  For  example,  when 
top-down housing supply targets in Regional Spatial Strategies were abolished, the number of 
new  dwellings  targeted  for  construction  across  the  country  fell  by  272,720.68  Strong  local 
political opposition to new housing remains in areas of high house prices, and the financial 
incentives  available  to  local  authorities  may  not  be  strong  enough  to  overcome  this.  It  also 
appears  that  the  UK  can  only  make  limited  progress  in  addressing  the  housing  supply 
shortage in the areas of highest demand without developing parts of the current "green belt" 
that restricts development around most of the UK's major cities. Many of the major housing 
developers have made it clear to investors that they are currently focused more on expanding 

64 Office for National Statistics (2012b). 
65 Office for National Statistics (2010). 
66 Statistics Sweden (2005). 
67  Residential  investment  is  a  flow  measure  which  could  be  used  as  a  proxy  for  the  change  in  residential  supply.  Building  permits  are  a 
leading indicator, showing how new construction is going to evolve in the near future. 
68 Morton (2012). 

47 

 
 
 
 
 
                                                            
margins than volumes,69 which could limit the positive impact of policies designed to boost 
housing supply in the short to medium term. 

Capacity in the planning system could also be a genuine constraint on development in 
coming years. Whether or not decisions on planning applications are timely and efficient can 
make a large difference to developers' risks and returns on potential residential construction 
projects, and hence the quantity and cost of new housing. Planning approvals have recently 
been  running  at  very  low  levels.70  Local  authorities  are  sharply  cutting  spending  on 
administering  the  planning  system  in  response  to  cuts  in  their  overall  budgets,  and  the 
government  has  decided  against  allowing  local  authorities  to  increase  user  charges  for 
planning-  and  housing-related  services  to  reflect  the  full  cost  of  the  system.  However,  the 
government  has  threatened  to  take  decision-making  powers  away  from  local  authorities 
which  are  too  slow  to  make  planning  decisions  or  take  an  excessively  anti-development 
approach.  

As well as leading to an insufficient and ageing housing stock, UK planning rules also 
often  heavily  restrict  modernisation  and  refurbishment  of  the  housing  stock  in  many 
places. Insulation of the housing stock in the UK also remains an issue which adds to energy 
costs and locks in resource inefficiency for the future. 

Government  has  also  introduced  a  range  of  financial  incentives  to  stimulate  lending  and 
development 

On  6  September  2012,  the  government  announced  a  list  of  new  measures  designed  to 
increase the supply of housing by making more financial incentives available. This was 
accompanied by a temporary reduction in  planning  regulations  for  modifications  to  houses. 
HM  Treasury  will  put  up  GBP  10  billion  in  guarantees  for  newly-built  houses  in  order  to 
reduce  the  borrowing  costs  of  housing  associations  and  private  developers.  "Section  106 
agreements" drawn up before the crisis, which require developers to provide a set proportion 
of  "affordable"  housing  on  a  given  site,  will  be  removed  in  cases  where  the  cross-subsidy 
would now make the project unviable. The Local Government Association estimate that there 
are plots for 400,000 homes on sites with planning permission in England and Wales where 
development is yet to start.71 

The  measures  taken  are  welcome  additions  to  the  government's  plan  for  stimulating 
house  building.  However,  it  is  unclear  if  the  government's  agenda  as  a  whole  will  be 
successful in leading to many more homes being built. House builders contend that there is 
a  lack  of  affordable  mortgages  which  is  blocking  the  system.  In  addition  to  the  capacity 
constraints  referred  to  above,  significant  scope  for  local  political  opposition  to  block 
residential development remains. 

Mortgage finance still restricted but debt write offs remain low 

In addition to a low level of construction, the activity in the wider housing market also 
remains  subdued.  The  housing  market  remains  stuck  in  a  low  transaction  equilibrium,  as 
affordability remains stretched for potential house purchasers, the availability (if not cost) of 
mortgage finance has been a constraint, but there have been relatively few forced sales. As 
Graph  49  shows,  the  number  of  loans  for  house  purchase  has  been  quite  stable  for  the  last 
three years, at less than half the rate before the crisis. The rate of re-mortgaging remains flat, 
at a fraction of the levels seen before the crisis. There has also been a decrease in households 

69 Deutsche Bank (2013). 
70 Home Builders Federation (2012). 
71 Local Government Association (2012). 

48 

 
 
                                                            
trading  down,  possibly  reflecting  the  low  transaction  equilibrium  in  which  the  housing 
market has been. There is some evidence that the cost of new mortgages is starting to fall and 
the  availability  of  mortgages  with  loan-to-value  (LTV)  ratios  of  over  75%  to  increase,72 
possibly in part due to the impact of the FLS. However, the vast majority of mortgages are 
still at an LTV of less than 90%, and 65% are at an LTV of less than 75%.73 At the end of 
2011, the Financial Services Authority (FSA) announced its Mortgage Market Review which 
aims to deter risky mortgage lending and ensure the sustainability of the mortgage market. A 
policy  statement74  was  announced  in  October  2012  with  most  of  the  changes  coming  into 
effect in April 2014. The main changes are that lenders are fully responsible for determining 
the customers’ affordability even if an intermediary is used, affordability assessments should 
allow for interest rate increases and interest-only loans should only be available where there 
is a credible strategy for repaying the mortgage.  

While the rate of mortgage arrears and house repossessions did rise after the onset of 
the  crisis,  they  remain  quite  low.  As  shown  in  Graph  50,  a  little  more  of  than  1%  of 
mortgages  are  in  arrears  and  the  annual  repossession  rate  is  below  0.5%.  Both  arrears  and 
repossessions  have  remained  much  lower  than  the  levels  they  reached  in  the  early  to  mid-
1990s, when interest rates were much higher. The Council of Mortgage Lenders75 forecasts 
arrears and repossessions to rise only very slightly over the next two years, during which time 
interest rates are expected to remain low (see Graph 58). As discussed in Section 3.2.3, there 
are risks that rising interest rates, higher unemployment or possibly a house price crash could 
lead to a less benign outcome. 

Graph 49: Approvals of loans secured on 
dwellings 

Graph 50: Mortgage arrears and 
repossession rates 

t

n
e
c

r
e
P

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

0
9

1
9

2
9

3
9

4
9

5
9

6
9

7
9

8
9

9
9

0
0

1
0

2
0

3
0

4
0

5
0

6
0

7
0

8
0

9
0

0
1

1
1

Mortgage arrears (lhs)

Properties taken into possession  (rhs)

Source: Bank of England 

Source: Department for Communities and Local Government 

Average interest costs fell in the crisis, and most mortgages are now variable rate, but rates 
for high LTV loans are much higher 

Average mortgage costs fell following the base rate fall, then stabilised, but a minority 
of  borrowers  are  trapped  on  high  rates.  When  the  Bank  of  England  cut  the  base  rate 
sharply at the onset of the crisis, from 5.75 in July 2007 to 0.5 in March 2009 where it has 

72 Bank of England (2012d). 
73 Financial Services Authority (2012b). 
74 Financial Services Authority (2012a). 
75 Council of Mortgage Lenders (2012). 

49 

 
 
 
                                                            
since remained, the gap between the average interest rate paid on mortgages and the base rate 
increased  sharply,  even  as  average  mortgage  rates  fell.  Before  2008,  almost  no  mortgage 
holders paid more than 2 pp. above the base rate, but since 2009 nearly half have been paying 
more than 3 pp. above base rate.76 Initially, this was largely due to a substantial apportion of 
mortgage holders being on fixed rates with interest rates dating from pre-crisis conditions. As 
these fixed rate deals gradually expire, mortgage holders may either move onto a variable rate 
or  sign  up  for  another  fixed  rate  deal  at  lower  post-crisis  interest  rates.  The  proportion  of 
mortgage holders who are currently on a variable rate has increased from approximately half 
at the onset of the crisis to more than 70%.77 

However,  there  has  also  been  the  growth  of  a  "dual"  mortgage  market  where  those 
taking  out  new  mortgages  with  a  large  deposit  pay  a  much  lower  interest  rate  than 
people  with  a  high  LTV,  whether  for  new  or  older  mortgages.  As  shown  in  Graph  51, 
banks have been increasing their standard variable rates (SVRs), which a growing proportion 
of mortgage holders are on, although the FLS may help to halt or partially reverse this trend. 
Many people with a high LTV loan are unable to re-mortgage because they are seen as too 
risky to be accepted by other lenders and are therefore effectively "trapped" on the existing 
SVR.  Most  of  these  mortgage  holders  would  not  be  eligible  for  the  various  government 
policies to aid first time buyers, purchases of new houses or loans for other new mortgages. A 
higher cost and restricted availability for high LTV mortgages is justified by the greater risk 
and  the  need  for  banks  to  hold  more  capital  against  them,  but  the  continued  rise  on  SVRs 
could also be a reflection of an appreciation by the banks that they have a captive market.  

Graph 51: Quoted interest rates on fixed 
rate and floating rate mortgages 

Source: Bank of England 

A rise in household saving has not translated into more "active" deleveraging by mortgage 
holders 

The  household  savings  rate  picked  up  sharply  from  historically  low  levels  in  the  pre-
crisis  years  (below  2%  of  GDP  in  2007)  as  households  increased  their  precautionary 
saving and began deleveraging from high levels of cumulated debt. Although the savings 
rate  rose  rapidly  during  the  recent  crisis,  it  had  until  recently  remained  lower  than  in  the 

76 Financial Services Authority (2012). 
77 Financial Services Authority (2012). 

50 

 
 
                                                            
aftermath  of  the  recessions  of  the  1980s  and  1990s,  as  shown  in  Graph  52.  The  household 
savings rate picked up to 7.7% in the third quarter of 2012, aided by stronger growth in total 
household  incomes  and  continued  precautionary  saving  in  an  uncertain  macroeconomic 
environment.  Many  households  that  are  not  currently  home  owners  are  also  likely  to  have 
increased  their  saving  on  the  expectation  that  they  will  now  need  to  accumulate  a  larger 
deposit before they can obtain a mortgage. 

Graph 52: Savings rate and growth in real 
household disposable income 

Source: Office for National Statistics 

Despite  a  higher  saving  rate,  the  rate  of  "active"  deleveraging  by  households  making 
repayments  over  and  above  regular  mortgage  servicing  requirements  does  not  appear 
to  have  risen.78  Although  debt  servicing  costs  having  fallen  significantly  for  many 
borrowers, falling real wages and an increased risk of unemployment have placed pressure on 
the finances of many households. Unlike many other countries, mortgage interest is not tax-
deductible in the UK so there is no explicit tax incentive to avoid paying off mortgages early.  

Unsecured lending has stretched the finances of a minority of households  

The stock of non-secured lending is limited in aggregate, but it contributes to financial 
pressure  on  poorer  households.  Lower  income  households  spend  a  larger  proportion  of 
their  incomes  on  debt  repayments,  although  they  are  less  likely  than  higher-income 
households to be home owners.79 Households with debt in the bottom decile have four times 
their annual income in debt and pay 47% of their gross monthly income in servicing this debt. 
Low income households instead tend to have more unsecured debt, which is usually subject 
to higher interest rates in part because it does not have property as collateral. A 2011 NMG 
Consulting  Survey  found  that  of  unsecured  borrowers  benefiting  from  some  form  of 
forbearance,  47%  said  that  they  would  be  behind  on  their  debt  repayments  without  the 
forbearance and that another 31% would only be able to keep up payments with difficulty.80 
Only 28% of secured borrowers receiving forbearance said they would be behind with their 
payments without the forbearance, even though their debts tend to be larger. 

78 Reinold (2011). 
79 Whittaker (2012).  
80 Bank of England (2012a). 

51 

 
 
                                                            
High housing costs also put pressure on tenants, and renting is not seen as a desirable long 
term option   

The  UK  home  ownership  rate  has  been  falling  for  the  last  decade  as  an  increasing 
number  of  households  have  been  priced  out  of  home  ownership.  The  home  ownership 
rate has fallen from 70% in 2002 to 65% in 2011, while the proportion of households renting 
privately  has  increased  from  10%  to  17%  over  the  same  period.81  While  there  have  been 
some  recent  signs  of  a  pick-up  in  mortgage  market  activity,  much  of  this  appears  to  be  for 
prime  and  buy-to-let  lending.82  The  private  rented  sector  in  the  UK  is  dominated  by  short 
term, unsecure tenancies.83 Tenancy agreements tend to set for a relatively short fixed period, 
following which they revert to a rolling basis (running on a week-to-week or month-to-month 
basis). Notice is usually given on a one to six month basis. One reason for the flexibility and 
dominance of short term tenancies in the private rental market renting is that it has generally 
seen as a temporary solution with most people having the aim of buying their own house at 
some point in the future.  

On average it is tenants not home owners who have the highest housing costs relative to 
incomes. Graph 53 shows that the rate of home ownership in the UK is similar to the euro 
area average, although home ownership has been falling in the UK. The average housing cost 
overburden rate84 for UK owner-occupiers in 2008-2010 was only 10.6%, also similar to the 
euro  zone  average,  although  this  is  currently  being  held  down  by  low  interest  rates.  In 
contrast the housing cost overburden rate for tenants was 46.1% in 2010, much higher than 
the EU average and reflecting the generally high cost of land and housing in the UK. When 
the  cost  of  renting  rises  it  quickly  impacts  on  almost  all  tenants  in  a  flexible  private  rental 
market  like  the  UK,  whereas  a  rise  in  the  cost  of  buying  a  house  only  directly  affects  the 
subsequent flow of purchasers, not the existing stock of home owners. 

Graph 53: Housing tenure and housing cost 
overburden rates (2008-2010 average)85 

)

%

(
n
o

i
t

l

a
u
p
o
p

f

o
e
r
a
h
S

United
Kingdom
EA17

EU27

80

70

60

50

40

30

20

10

0

Tenant

Owner

Low inc.

High inc.

Housing cost overburden 
rate 

Owner occupancy rate 

Source: Commission services 

81 Department for Communities and Local Government (2012). 
82 Bank of England (2013a). 
83 Shelter (2012). 
84  The  housing  cost  overburden  rate  is  the  %  of  the  population  living  in  households  where  the  total  housing  costs  ('net'  of  housing 
allowances) represent more than 40 % of disposable income ('net' of housing allowances). 
85  The  left  hand  side  illustrates  housing  cost  overburden  rate,  The  right  side  shows  the  percentage  of  low  and  high  income  population 
owning a house. Low income is defined to be below the 6th decile and high income above the 6th decile of the distribution. 

52 

 
 
 
 
 
                                                            
Despite  the  financial  pressure  on  tenants,  rents  are  still  historically  low  relative  to 
prices. As shown in Graph 46 the house price-income ratio remains elevated. House prices 
are  still  also  high  relative  to  rents,  in  common  with  some  other  EU  Member  States  that 
experienced large house price booms in the years to 2007. While UK house prices have been 
relatively flat since 2010, rents have been increasing significantly. An increasing number of 
households  priced  out  of  the  option  of  home  ownership  have  been  forced  to  rent  privately, 
which  in  a  context  of  a  restricted  housing  supply  is  pushing  up  rental  prices  despite  the 
weakness  in  real  income  growth.  Subsidies  for  private  rented  housing  provided  through 
Housing  Benefit  have  also  acted  to  increase  effective  demand  and  helped  to  bid  up  both 
private rental and sale prices of housing in high demand locations, although this is starting to 
be  addressed  by  the  government.  Subsidies  for  tenants  in  scarce  social  housing  are  also  a 
barrier to labour mobility. If a combination of high house prices and tighter lending standards 
persists, the role of long term private renting will continue to expand, particularly for middle 
income households.  

Housing taxation still characterised by major distortions 

The  UK  system  combines  a  regressive  recurring  tax  (Council  Tax)  with  a  progressive 
transaction  tax  (Stamp  Duty  Land  Tax  or  SDLT).  The  government  rejected  the 
introduction  of  a  'mansion  tax'  which  would  levy  taxes  on  higher  value  properties  and 
partially address the currently regressive structure of Council Tax. Two problems exist with 
the  current  council  tax  system:  the  system  is  based  on  valuations  linked  to  the  price  of 
housing  of  1991;  and  it  is  regressive  as  properties  in  the  lower  valuation  bands  pay 
proportionally  more  tax  relative  to  properties  in  higher  valuation  bands.  Tax  bills  are 
therefore not updated in line with house price changes, which removes one potential means 
by which the volatility of house prices might be reduced, as changes in tax liability should be 
capitalised  into  house  prices.  SDLT  is  distortionary,  discourages  labour  mobility  and  is 
highly  cyclical.  SDLT  revenues  halved  from  1%  of  GDP  in  2007  to  0.5%  in  2009, 
contributing  disproportionately  to  the  growth  of  the  UK  budget  deficit.  Despite  the  pro-
cyclicality of SDLT revenues, the sharp house prices in the decade before the crisis suggest 
the tax was not effective in dampening the house price cycle or preventing speculation when 
the  market  was  rising.  A  top  7%  rate  was  introduced  in  March  2012  for  the  purchase  of 
residential  properties  worth  over  GBP  2  million  (increased  to  15%  if  purchased  by  certain 
non-natural persons), but no wider reform has been carried out in this tax. Undeveloped land 
is taxed on sale or transfer but not recurrently on its annual economic value. 

There  are  some  biases  in  the  UK  tax  system  towards  home  ownership,  but  mortgage 
interest  is  not  deductible  in  the  UK.  Rental  income  is  taxable  in  the  UK  while  imputed 
rents from owner-occupation are not. A combination of the exemption of primary residences 
from  capital  gains  tax,  and  the  exemption  of  the  first  GBP  325,000  of  bequests  from 
inheritance  tax  (now  effectively    GBP  650,000  for  couples),  means  that  capital  gains  from 
increases in house prices can be retained and transmitted inter-generationally with relatively 
little taxation. 

Risks  associated  with  a  minority  of  over-indebted  households  and  structurally  high  house 
prices are currently masked by low interest rates and forbearance  

Household debt is currently falling due to low levels of new lending, and some further 
deleveraging is likely in the short term, but in the medium to long term household debt 
is likely to remain high. Despite falling by 17% in real terms since 2008, UK house prices 
remain  high  relative  to  incomes,  supported  by  a  shortage  of  housing  supply  and  loose 
monetary  policy.  The  government  has  put  in  place  a  number  of  regulatory  and  fiscal 

53 

 
 
measures  aimed  at  increasing  residential  construction,  but  it  is  not  yet  clear  how  effective 
these will be in addressing housing supply shortages. A sharp fall in house prices remains a 
possibility,  but  household  debt  is  likely  to  pick  up  again  in  the  medium  term,  as  housing 
transactions return to more normal levels, even if many middle income households continue 
to be priced out of home ownership and the distribution of net wealth remains polarised. 

3.2.3.  What  risks  do  private  debt  dynamics  and  servicing  costs  pose  to  stability  and 

growth?  

Although the current level of defaults is modest and debt servicing costs are manageable 
at an aggregate level, a relatively high stock of private debt poses a number of potential 
risks  to  both  UK  growth  and  to  financial  stability.  A  mix  of  risk  aversion  and  credit 
constraints should support some further overall private sector deleveraging in the short term. 
However, there is a tension between a need for higher gross credit flows to finance economic 
growth  through  corporate  investment  and  residential  construction,  and  a  need  for 
deleveraging and effective financial regulation to prevent the build-up of further imbalances 
and  financial  sector  risks  in  the  future.  Sustainable  growth  is  also  an  important  part  of 
ensuring that the ratios of UK debt to GDP, especially public debt, remain sustainable and do 
not generate excessive risks to macroeconomic stability.  

Reforms to financial sector regulation should reduce future risks of irresponsible lending 

As Graph 54 shows, UK banks are now better-capitalised than before the crisis hit and 
compare well with international peers. The more stable financial position of UK banks is 
reflected in three banks being among the five largest positive contributors in the rise on the 
FTSE 100 index in 2012, although market value of the major UK banks' share equity is still 
only two-thirds of the book value. The Bank of England has acknowledged investor concerns 
that banks may have been aggressively interpreting risk weights, implying that banks' capital 
buffers may not be as large as the headline figures imply.86 

Graph 54: Banks' tier 1 capital ratios (%) 

Source: SNL financial, published accounts and Bank of 
England calculations 

86 Bank of England (2012c). 

54 

 
 
 
                                                            
The  Financial  Services  Bill,  which  would  rearrange  the  UK's  system  of  financial 
supervision, is in the process of being agreed in the UK Parliament. Once implemented 
day-to-day supervisory activity will move to the newly created Financial Conduct Authority; 
the Prudential Regulatory Authority, responsible for macro-prudential affairs, will sit inside 
the  Bank  of  England;  and  the  Financial  Policy  Committee  of  macro-prudential  experts  will 
exist alongside the Monetary Policy Committee at the top of the central bank to complement 
its monetary role. While the authorities need to be alert and ready to respond to any signals of 
excessive risky lending that could threaten future financial stability, the economy would also 
benefit from a period of regulatory stability.  

In the medium term a normalisation of lending conditions could see household debt start to 
rise again 

The insufficient and rigid supply of housing in the UK continues to expose the country 
to higher and volatile house prices, and consequently high household debt. As Graph 55 
shows, the independent Office for Budget Responsibility (OBR) forecast that household debt 
will soon start to rise again relative to disposable incomes, although at a much less rapid rate 
than seen before the crisis. As discussed in Section 3.2.2, the fundamentals point to UK house 
prices  remaining  high  relative  to  incomes,  and  in  the  short  term  low  interest  rates  are 
supporting asset prices despite a weak domestic economy. A sustained and significant fall in 
household  debt  is  only  likely  if  both  house  prices  fall  relative  to  disposable  income,  and 
levels of home ownership continue to decline.  

Graph 55: UK household debt: 2009-2017 

Source: Office for Budget Responsibility 

The  optimal  scenario  for  the  short  and  long  term  growth  and  stability  of  the  UK 
economy would be a gradual elimination of the housing shortage accompanied by house 
prices  falling  gradually  in  real  terms,  without  sharp  nominal  price  falls.  However,  as 
discussed above, it is unclear how far housing supply will expand, and UK house prices have 
historically been unstable. Rapid house price falls would risk pushing many households into 
negative  equity  and  create  negative  wealth  effects.  In  contrast,  significant  house  price  rises 
would increase risks to macroeconomic stability while also pushing up household debt levels.  

If credit is too tight it could harm the prospects for addressing the UK's investment deficit 

The UK also has a need for increased investment, which would not be helped by rapid 
deleveraging  or  tight  credit  conditions.  The  challenge  must  be  balanced  with  the  need  to 

55 

 
 
reduce the risk of future debt-related instability in the UK macroeconomy. An unprecedented 
drop in business investment after 2007 saw the UK level of gross fixed capital formation as a 
share of GDP fall to 14.3% in 2011, the third lowest level in the EU-27. All types of private 
investment (business, residential and infrastructure) continue to be very weak in the UK. 

This  is  holding  back  short-term  growth,  preventing  the  "rebalancing"  of  the  UK 
economy  from  consumption  and  debt  towards  investment  and  net  exports,  and 
exacerbating existing weaknesses (of low capital stock, housing shortage and inadequate 
and  congested  infrastructure).  The  UK  also  risks  losing  the  capacity  to  cost-effectively 
ramp  up  investment  later  if  a  combination  of  weak  demand  and  tight  credit  conditions 
continues to drive low investment and a loss of construction capacity.  UK investment needs 
in  transport  and  energy  infrastructure,  and  related  government  initiatives,  are  discussed  in 
Section 3.1.2. 

There are specific issues with the structure of the residential construction market and 
the  incentives  for  developers  that  may  be  reducing  the  response  of  housing  supply  to 
market  signals  and  to  housing  policy.  As  land  is  expensive  and  developers  typically 
purchase the land on which they subsequently build, a large part of developers' profitability 
rests on how successfully they play the land market and negotiate the planning system. This 
creates significant barriers to entry but also often creates incentives for developers to hang on 
to undeveloped land with planning permission, rather than building on it as soon as possible, 
either in the hope of future price rises or in order to avoid having to write down the value of 
land bought in the run up to the crisis when land prices were higher than they are now.87 It is 
currently the stated policy of most major residential developers to build margins rather than 
market  share,  which  risks  diverting  government  subsidies  into  the  profits  of  developers  or 
into higher house prices, rather than into a net increase in housing supply. Developers' share 
prices  have  recently  increased  significantly  without  an  increase  in  construction  volumes.88 
Developers  have  also  expressed  concerns  that  increased  capital  requirements  for  bank 
financing commercial real estate could reduce new development in that sector.89 

Excessive and prolonged forbearance could harm stability and growth 

One  of  the  aims  of  loose  monetary  policy  is  to  aid  short-term  growth  by  preventing 
excessively rapid deleveraging in the short term, but this risks harming the functioning 
of the economy if it persists for too long. In particular, in a climate of low interests rates 
and incentives for banks to delay calling in or writing down loans that are unlikely to be paid 
back,  there  is  a  risk  that  large  parts  of  banks'  loan  books  become  "ossified",  crowding  out 
new lending, and that bank balance sheets continue to carry hidden risks. As discussed above, 
the data suggest that turnover in the loans stock is low and falling, driven by a weakness in 
new lending.90 

There is some evidence of "zombie" firms which continue operating despite having little 
prospect of paying off their stock of debt, aided by a low interest environment. R3, the 
insolvency  industry  trade  body,  found  that  160,000  companies  are  only  able  to  pay  the 
interest on their debt but do not see a prospect of being able to pay back the principal, and the 
number is rising.91 Corporate insolvencies have remained low in the UK, despite more firms 
reporting  that  they  are  loss-making,  as  shown  in  Graph  56.  If  banks  are  seeking  to  reduce 
their balance sheets but hesitating to recognise losses from a potentially stale stock of debt, it 

87 Morton (2012a). 
88 Financial Time (2013b). 
89 Financial Times (2013a). 
90 Bank of England (2013b). 
91 R3 (2013). 

56 

 
 
                                                            
could  both  store  up  risks  to  financial  stability  and  prevent  credit  from  being  reallocated  to 
more  dynamic  and  productive  sectors  of  the  economy.  It  could  also  contribute  to  low 
productivity  as  weaker  firms  fail  to  exit  the  market.  Evidence  from  the  ONS92  shows  a 
widening of the dispersion of productivity performance across firms in 2008 and 2009, with a 
possible  weakening  of  competitive  pressure  contributing  to  this.  More  recent  data  on  firm 
level productivity is not available but in a climate of weak growth, weak investment and low 
insolvencies, it is likely that high firm-level dispersion of productivity has persisted. 

Graph 56:  Company liquidations in England 
and Wales and an estimate of loss-making 
companies 

35

30

25

20

15

10

5

0

t
n
e
c

r
e
p

35

30

25

20

15

10

5

0

)
0
0
0
'
(

r
a
e
y

r
e
p
s
n
o
i
t
a
d
u
q

i

i
l

f
o
r
e
b
m
u
N

4
8
9
1

8
8
9
1

2
9
9
1

6
9
9
1

0
0
0
2

4
0
0
2

8
0
0
2

…
2
1
0
2

Loss-making companies (lhs)

Company liquidations (rhs)

Source: Bureau van Dijk, The Insolvency Service and Bank of 
England calculations 
Note: 2012 figure estimated based on data for Q1 and Q2 

There is also a risk that access to finance policies could subsidise increased bank profits or 
private sector gearing more than growth 

Access  to  finance  policies  need  to  be  carefully  designed  and  monitored  to  ensure  they 
benefit  investment  and  growth  without  increasing  potential  macroeconomic  instability 
or subsidising banks or healthy firms. The FLS is incentivised by scale but not by sector or 
firm size. There is a risk that individual banks and building societies take advantage of the 
scheme without actually increasing their lending to credit constrained firms.  

If  housing  supply  remains  constrained  there  is  also  a  risk  that  the  FLS  ends  up 
channelling  money  into  bank  margins,  wealthier  households  or  inflating  the  price  of 
existing  housing.  Mortgage  lending  on  existing  houses  is  included  in  the  FLS,  not  just 
lending  to  finance  construction  or  business  investment.  It  is  therefore  at  least  as  much  of  a 
demand side as a supply side policy operating in a market with constrained supply. On the 
one hand, there are currently relatively few attractive investment options for households, and 
property  retains  a  number  of  tax  advantages,  as  set  out  in  Section  3.1.2  Bank  of  England 
evidence93  suggests  banks  are  looking  to  expand  their  volume  of  secured  lending  but  are 
reluctant  to  loosen  the  scoring  criteria  that  have  limited  loan  availability  to  households 
without large deposits.  On the other hand, the FLS and other drivers of lower bank funding 
costs  do  appear  to  be  leading  to  reductions  in  the  cost  of  credit  for  less  risky  borrowers, 

92 Field and Franklin (2013). 
93 Bank of England (2012a). 

57 

 
 
 
 
 
 
 
 
 
                                                            
which  may  lead  to  either  an  increase  in  remortgaging  or  bidding  up  the  prices  that  the 
existing pool of eligible borrowers are able to pay for housing. 

A  rise  in  interest  rates  could  cause  a  shake  out  of  non-performing  loans  and  hit  the 
macroeconomy, but does not look imminent 

Write-offs of all forms of debt rose after the onset of the crisis as shown in Graph 57, 
though much less for mortgages than other forms of debt. While the fall in interest rates 
in  2008-2009  reduced  debt  servicing  costs  for  most  borrowers  significantly,  a  moderate 
increase in insolvencies and unemployment led to unavoidable defaults. Write-offs rose most 
for consumer credit, where as discussed in Section 3.2.2, a minority of households have very 
high  debt  servicing  costs  although  consumer  credit  is  a  small  share  of  overall  lending  and 
poses  limited  risks  to  financial  and  macroeconomic  stability.  Despite  forbearance,  the 
defaults  rate  on  NFC  loans  has  also  risen.  Given  forecasts  that  the  UK  economic  recovery 
will continue to be muted, the Bank of England is not expected to significantly increase the 
base  rate for some  time. As shown in Graph 58 market expectations are that the bank base 
rate will still be below 1% until 2015. There are however two potential risks from the high 
private  debt  stock  when  interest  rates  do  rise.  If  interest  rates  rose  sharply,  it  would  risk 
making the interest burdens of large numbers of households and businesses unsustainable, as 
happened when official interest rates peaked in the early 1990s. This could generate business 
insolvencies,  repossessions  and  significant  losses  for  the  banking  system.  A  large  stock  of 
variable rate private debt also means that the sensitivity of aggregate debt servicing costs as a 
share of GDP to interest rate changes has increased.  

Graph 57: Write off rates on lending to UK 
businesses and individuals 

Graph 58: Bank of England base rate and 
forward market expectations 

8

7

6

5

4

3

2

1

0

-1

t
n
e
c

r
e
p

4
Q
3
9

4
Q
4
9

4
Q
5
9

4
Q
6
9

4
Q
7
9

4
Q
8
9

4
Q
9
9

4
Q
0
0

4
Q
1
0

4
Q
2
0

4
Q
3
0

4
Q
4
0

4
Q
5
0

4
Q
6
0

4
Q
7
0

4
Q
8
0

4
Q
9
0

4
Q
0
1

4
Q
1
1

Businesses

Mortgages

Consumer credit

Source: Bank of England 

Source: Bank of England and Bloomberg 

Mortgage  defaults  have  been  modest  to  date  but  could  increase  in  the  future  if 
unemployment or interest rates rise.  As  discussed  in  Section  3.2.2,  mortgage  arrears  and 
defaults have remained relatively low since the crisis, in contrast with some other European 
countries that saw housing market busts. Real wages have been weak but most people who 
remain  in  work  have  been  able  to  meet  mortgage  repayments,  which  have  often  fallen 
significantly  as  a  result  of  lower  interest  rates.  Except  for  the  depths  of  the  recession, 
redundancies have not been especially high. On the whole, it is the youth and those who are 
currently  excluded  from  the  option  of  home  ownership  who  have  been  hit  hardest  by  the 
recession  and  muted  recovery.  Fewer  existing  homeowners  have  suffered  from  long  term 

58 

 
 
 
unemployment.  However,  if  unemployment  does  rise  overall  it  could  lead  to  increased 
mortgage defaults. While interest rates may not rise until the economy and labour market are 
strengthening, households whose income has fallen permanently as a result of the crisis may 
get  into  difficulty  when  interest  rates  rise  back  towards  historical  norms.  This  may  for 
example include people who lost their previous job and have had to move into a lower paying 
sector  or  post,  or  households  that  have  moved  from  having  two  earners  to  one  earner. 
Households with high LTVs who are stuck on standard variable rates with limited scope to 
remortgage could be especially vulnerable. 

3.2.4.  Conclusions 

The level of household debt remains high and constitutes an imbalance. There has been 
some progress in deleveraging in both the corporate and household sectors but there is 
a tension between needs for further deleveraging and for improved access to credit to 
fuel an investment-led recovery. Aggregate debt service costs are sustainable at current low 
interest  rates  thus  short  term  pressures  are  low,  but  the  high  stock  of  household  debt  poses 
potential risks to both UK growth and to financial stability when interest rates rise. To date 
household  deleveraging  has  been  driven  more  by  a  low  level  of  new  lending  than  by  an 
increase in the rate at which existing debt stocks are paid or written off. The financial sector 
has returned to relative stability following the crisis and, although large, the balance sheets of 
UK  banks  are  not  expanding  rapidly.  There  is  a  tension  between  a  need  for  higher  gross 
credit  flows  to  finance  economic  growth  through  corporate  investment  and  residential 
construction,  and  a  need  for  deleveraging  and  effective  financial  regulation  to  prevent  the 
maintenance and future build-up of imbalances and financial sector risks. Low interest rates 
have partially masked the issue of a significant minority of very highly indebted households, 
and there is a risk of a sharp increase in mortgage arrears if official or effective interest rise 
significantly, or unemployment rises. Overall, it is currently unlikely that households will in 
aggregate see sustained strong deleveraging. 

59 

 
 
 
4. 

POLICY CHALLENGES 

The analysis in Sections 2 and 3 indicates that developments in external competitiveness and 
the  need  for  both  deleveraging  and  safeguarding  financial  stability,  without  unduly 
hampering growth, are the main challenges relating to macroeconomic imbalances in the UK. 

responses  were 

It should be recalled that these challenges were identified under the MIP in the first IDR and 
the  country-specific 
reflected  and 
relevant  policy 
recommendations  issued  for  the  UK  in  July  2012.  The  assessment  of  progress  in  the 
implementation of those recommendations will take place in the context of the assessment of 
the UK National Reform Programme and Convergence Programme under the 2013 European 
Semester.  Against  this  background,  this  section  discusses  different  avenues  that  could  be 
envisaged to address the challenges identified in this IDR.  

integrated 

in 

Concerning  the  challenge  of  improving  external  competitiveness,  a  number  of  different 
avenues can be considered as regards: 

Investment  in  infrastructure:  as  set  out  in  this  review  and  in  line  with  Council 
recommendations  issued  in  201294,  there  is  significant  scope  for  the  UK  to  improve  its 
transport infrastructure by addressing shortages in airport and seaport capacity, tackling road 
congestion and upgrading its rail network. In the first instance, this would entail meeting the 
substantial  transport  infrastructure  investment  needs  indicated  in  the  National  Infrastructure 
Plan  2011,  much  of  which  are  currently  unfunded,  by  identifying  additional  sources  of 
funding, addressing high unit costs in transport in the UK, and removing regulatory barriers 
to investment. In order to reconcile the need for increased investment in infrastructure with 
the  budgetary  constraints  arising  from  consolidation  needs,  the  UK  authorities  could 
endeavour to harness private funding by introducing user pricing schemes where appropriate, 
and  by  relying  on  the  strength  of  the  government's  balance  sheet  to  provide  guarantees. 
Careful  design  and  implementation  of  such  schemes  is  crucial  to  safeguard  their  value  for 
money. This would call for a clear division of risks between public and private sectors, and 
an avoidance of other deficiencies identified in previous private finance initiatives. 

Skill gaps: exporters require a labour force with the right skills. Intermediate and advanced 
technical  skills  are  an  area  where  evidence  suggests  that  gaps  and  recruitment  difficulties 
persist. As set out in this review, labour productivity growth in manufacturing has been slow 
in the UK and lags behind that of other advanced economies. Effective implementation of the 
national  apprenticeship  programme  could  help  close  the  skills  gap.  This  would  require 
apprenticeships  to  be  high  quality  and  to  equip  participants  with  the  skills  needed  by  the 
tradable  sectors  of  the  economy.  There  is  scope  for  further  cooperation  between  the 
Government and employers to increase the number of apprenticeships and foster work-based 
experience.  Appropriately  addressing  the  related  2012  Council  recommendation  on  young 
people's skills and early school leaving (which is comparatively high in the UK) would also 
contribute positively in this regard. Finally, reinforcing the role of science, engineering and 
foreign  languages  in  educational  curricula  could  also  help  the  educational  system  meet  the 
needs of employers, in particular in export-oriented sectors. 

Access to finance: difficulties in accessing finance are a cross-cutting problem at the current 
juncture,  particularly  for  smaller  and  younger  companies.  They  could  be  addressed  at  an 

94 The Council recommendations mentioned in this section refer to Recommendation 2012/C 219/27 as published in the Official Journal of 
the European Union. 

60 

 
 
 
 
                                                            
economy-wide  level,  as  well  as  with  regard  to  the  specific  financing  instruments  for 
exporting  companies.  The  UK  authorities  have  implemented  a  number  of  initiatives  which 
respond to the 2012 Council recommendations on access to finance. Some of these initiatives 
are still embryonic, such as the British Business Bank and, as discussed below, the Funding 
for Lending Scheme (FLS). Overall, cross-cutting measures promoting access to finance can 
foster entry into, and expansion of, the exporting sector, which  has  become  more  attractive 
following the post-crisis depreciation of sterling. Measures promoting financing instruments 
that are specific to the exporting sector could also be strengthened, subject to state aid rules.  

Other elements: the external performance of the UK economy is affected by a multitude of 
other factors, some of which can be shaped by policy action. The geographical composition 
of UK exports continues to reorient itself towards faster-growing markets, and the initiatives 
of government bodies such as UK Trade and Investment can continue to have positive effects 
in  this  regard.  There  is  also  scope  to  further  reinforce  the  links  between  the  strong  UK 
research base and industrial sectors. Finally, the UK witnessed strong unit labour cost (ULC) 
dynamics  in  the  pre-crisis  years.  In  order  to  maintain  the  price  competitiveness  of  the  UK 
economy, it is desirable that ULC growth does not outpace productivity gains. 

Concerning  the  challenge  linked  to  the  needs  for  deleveraging,  maintaining  financial 
stability and avoiding unduly compromising investment and growth, there are a number of 
issues that can be considered: 

Increasing residential construction: alleviating the housing shortage over the medium term 
would reduce the risk of imbalances related to high house prices and consequently household 
debt persisting into the long term. This could be achieved by a combination of ensuring that 
interpretation of the new planning system is clear and that it is effectively resourced, further 
simplifying the planning system, relaxing green belt restrictions that prevent development of 
new  land  in  many  of  the  areas  of  highest  demand,  increasing  the  fiscal  incentives  given  to 
local  communities  that  allow  development,  and  potentially  a  land  value  tax.  Undeveloped 
land with planning permission, which is not currently subject to recurrent taxes as the system 
focuses on taxing existing property, could also be taxed on its imputed economic rent on an 
annual  basis.  This  could  help  incentivise  developers  to  build  housing  rather  than  hold  onto 
undeveloped  land  with  planning  permission  in  the  hope  of  a  rise  in  land  values.  The 
government  could  also  look  for  ways  to  promote  greater  competition  in  the  residential 
development sector by lowering barriers to entry and changing the incentives for firms. The 
UK  sector  is  dominated  by  firms  which  both  purchase  land  and  build  property.  The  UK 
authorities  could  look  at  further  options  for  encouraging  higher  volumes  of  self-build 
construction  projects,  as  are  seen  in  many  other  European  countries,  although  reducing  the 
barriers imposed by the planning system will be key. 

Property taxation: the UK system combines a regressive recurring tax (Council Tax) with a 
progressive transaction tax (the Stamp Duty Land Tax or SDLT). The recurrent taxation of 
land and property ownership is in general relatively economically efficient but there is some 
scope  to  reform  UK  property  taxes  to  make  the  system  as  a  whole  less  distortionary  and 
regressive.  Transaction-based  property  taxation  could  discourage  speculation,  but  it  also 
involves significant distortions and can generate highly cyclical revenues. Reform of Council 
Tax  could  be  considered  so  that  it  both  reflects  current  property  values  (the  system  is  now 
linked to the price of housing in 1991) and is paid as a fixed percentage of the property value 
rather than the existing regressive system of bands. This could be done in combination with a 
broader  land  value  tax  as  noted  above.  Such  reforms  could  improve  the  functioning  of  the 

61 

 
 
 
housing  market  and  the  efficiency  of  the  tax  system,  promote  better  labour  mobility  and 
efficient  capital  allocation.  It  could  also  potentially  contribute  to  fiscal  consolidation  if  net 
revenues  increased.  There  would  be  some  risks  involved  in  raising  property  taxes  for 
households  with  existing  problems  servicing  their  mortgages  in  an  environment  of  low 
liquidity,  but  this  is  unlikely  to  include  many  of  the  higher  income,  high  net  wealth 
households that would predominantly be affected by a flatter rate Council Tax replacement. 

Rental market: a combination of high house prices, stretched household finances and more 
responsible lending criteria are likely to continue to exclude many middle income households 
from  the  option  of  home  ownership.  Subsidies  for  private  rented  housing  provided  through 
Housing Benefit have acted to increase effective demand and helped to bid up both private 
rental  and  sale  prices  of  housing  in  high  demand  locations,  although  this  is  starting  to  be 
addressed by the government. Subsidies for tenants in scarce social housing are also a barrier 
to labour mobility. The private rental market is currently dominated by short term, unsecure 
tenancies. Long-term private renting could be made more attractive as a long term option by 
improving the current rental framework so as to promote greater use of longer term contracts 
that  give  more  security  to  tenants,  and  by  a  further  professionalisation  of  the  sector.  This 
could improve the welfare of households who rent and help tackle high levels of household 
debt by reducing the pressure that UK households often feel to borrow heavily to get on the 
property ladder as soon as possible.  

Financial stability: economic policy as a whole needs to carefully balance a pressing need 
for  new  lending  to  support  investment  and  growth,  with  a  long  term  need  for  deleveraging 
and macroeconomic and financial stability. In the short term, loose monetary policy remains 
appropriate in a context of weak domestic and external demand, but this should not be at the 
cost  of  allowing  existing  imbalances  to  remain  unresolved  indefinitely.  The  government's 
focus  on  broader  actions  to  improve  access  to  finance  is  also  appropriate  given  that  credit 
constraints  are  contributing  to  low  investment  and  weak  growth.  For  the  FLS  and  other 
access to finance policies to maximise their impact they need to focus as far as possible on 
supporting an increase in productive investment rather than bidding up the price of existing 
assets.  Action  to  address  the  problems  of  companies  with  limited  prospects  of  paying  back 
their  outstanding  debts  and  hidden  risks  in  bank  balance  sheets  –  namely  through  higher 
levels  of  provisioning  by  banks  and,  possibly,  further  company  debt  restructurings  –  could 
both  deal  with  risks  to  the  stability  of  the  financial  system  and  support  the  reallocation  of 
resources  through  investment  in  more  productive  firms  and  sectors.  Effectively  addressing 
the  recommendation  of  the  interim  Financial  Policy  Committee95  that  banks  need  to  assess 
more  realistically  their  true  capital  adequacy  ratios  could  help  dissipate  concerns  about 
hidden  risks  in  banks'  balance  sheets.  This  would  imply  taking  action  to  ensure  that  bank 
capital  and  provisions  reflect  proper  asset  valuations  and  that  a  realistic  assessment  of 
expected losses and a prudent calculation of risk weights are applied. 

95 Financial Policy Committee (2012). 

62 

 
 
                                                            
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