COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - United Kingdom 2014
Date: 2014-03-05
Institutions: European Commission
Subjects: United Kingdom, capital depreciation, competitiveness, cost of borrowing, economic growth, indebtedness, macroeconomics, property market, real estate credit, stability pact, trade balance













EUR-Lex - 52014SC0091 - EN











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52014SC0091

COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - United Kingdom 2014 /* SWD/2014/091 final */









Results of in-depth reviews under
Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic
imbalances
The United Kingdom continues to experience macroeconomic
imbalances, which require monitoring and policy action. In particular,
developments in the areas of household debt, linked to the high levels of
mortgage debt and structural characteristics of the housing market, as well as
unfavourable developments in export market shares, continue to warrant
attention. 
More specifically,
while recent growth in economic activity is welcome, it is driven mostly by
household consumption and is accompanied by a rising current account deficit.
Business investment and net exports are yet to pick up from their current low
levels. Containing high indebtedness, in particular of the household sector,
while minimising the impact on investment and growth, would help limit
medium-term risks and vulnerability to rises in the cost of borrowing. Credit
growth for mortgage loans has been modest but rising from high pre-existing
levels of household indebtedness. The risks in the housing sector relate to a
continuing structural under-supply of housing; the relatively slow response of
supply to increases in demand results in high house prices, particularly in
London and the Southeast, and in household mortgage indebtedness. While the
declining export market share is unlikely to pose short-term risks, together
with the current account deficit, it still points to structural challenges.
These are related to skills gaps and a low level of infrastructure endowment.
As regards public finances, the UK seems to continue missing its headline
deficit targets and its structural adjustment targets by wide margins.
Excerpt of country-specific findings on The United Kingdom, COM(2014)
150 final, 5.3.2014
Executive Summary and Conclusions 7
1.       Introduction  9
2.       Macroeconomic
Developments 11
3.       Imbalances
and Risks 17
3.1.     Export
Share and Competitiveness 17
3.1.1.  The current
account deficit 17
3.1.2.  Export shares
challenge  18
3.1.3.  The impact of
the depreciation  21
3.1.4.  Policy
responses: Infrastructure, skills and SME finance  24
3.1.5.  Conclusions 29
3.2.     Private
Sector Indebtedness 31
3.2.1.  Introduction  31
3.2.2.  Trends and
developments 31
3.2.3.  Credit
supply  33
3.2.4.  Cost of
credit 36
3.2.5.  Near-term
outlook for credit supply and demand  37
3.2.6.  Risks 37
3.2.7.  Government
policy – developments and impact 40
3.2.8.  Conclusion  42
3.3.     The Housing
Sector and Household Mortgage Indebtedness 42
3.3.1.  Introduction  42
3.3.2.  Trends and
Developments 43
3.3.3.  Risks 49
3.3.4.  Government
policy - responses and challenges 54
3.3.5.  Conclusion  57
4.       Policy
Challenges 59
References 62
LIST OF Tables
2.1.     Key
economic, financial and social indicators - United Kingdom   15
3.1.     Elasticity
of supply  53
LIST OF Graphs
2.1.     External
and domestic demand - growth contribution  11
2.2.     Youth
unemployment rate (% of youth labour force aged 15-24) 12
2.3.     Debt
Decomposition, all sectors, consolidated   13
2.4.     Decomposition
of credit flows, consolidated   13
3.1.     Decomposition
of external position (current and capital accounts) 17
3.2.     Export
shares 18
3.3.     Investment
and gross savings 18
3.4.     UK's world
market share for services 19
3.5.     Goods
export: geographical and sectoral composition  19
3.6.     Dynamism
and competitiveness of goods export 21
3.7.     Export
destinations, goods 21
3.8.     Exchange
rate developments 21
3.9.     Deflator of
exports 22
3.10.   Decomposition
of REER  22
3.11.   Nominal effective
exchange rate (NEER) 22
3.12.   Unit labour
costs and its components 22
3.13a.                                                                                    UK firm-level Return on Assets, industry medians 23
3.13b.                                               France, Italy and Spain firm-level Return on Assets, industry
medians 23
3.14.   Transport
gross investment spending (exluding maintenance) 24
3.15a.                                                                                                      Beveridge curve - pre- and post-crisis 26
3.15b.                                                              Beveridge curve - by duration of unemployment, after 2008  26
3.16.   Lending to UK
private non-financial corporations 28
3.17.   Corporate
credit costs by firm size  29
3.18.   Lending to UK
private non-financial corporations 29
3.19.   Households'
and PNFCs' indebtedness 31
3.20.   PNFCs' debt
as percentage of gross operating surplus 31
3.21.   Measures of
PNFCs' leverage  32
3.22.   Household
debt as a percentage of gross disposable income  32
3.23.   Composition
of household deleveraging  32
3.24.   Gross operating
surplus and household gross disposable income  33
3.25.   Household
saving ratio  33
3.26.   Credit growth
by sector 33
3.27.   Economic
sentiment and consumer confidence  36
3.28.   PNFCs' cost
of borrowing  37
3.29.   Stock of UK
loans by sector a) 39
3.30.   PNFCs'
profitability ratios 39
3.31.   PNFCs'
financial assets 39
3.32.   Liabilities
and Loans/Deposits Ratio, Financial Corporations 40
3.33.   Homeownership
rate  43
3.34.   Property
transactions 43
3.35.   Number of
loans approval for house purchase and for remortgaging, seasonally adjusted   43
3.36.   Measures of
near-term demand   43
3.37.   Quoted
mortgage rates 44
3.38.   2-Year fixed
mortgage Rate and 2-Year Swap Rates 44
3.39.   Net balance
of consumers that believe that now is a good time in which to make a major
purchase  44
3.40.   Private
sector housing starts and completions 45
3.41.   House Price
Index  46
3.42a.                                                                           Selling price achieved as a share of the asking price  46
3.42b.                                                                                         House price expectations 12-months ahead   46
3.43.   House prices
to disposable income  47
3.44.   Price to rent 47
3.45.   Mortgage
interest payments as a percentage of household disposable income  47
3.46.   Regional
house price developments 48
3.47.   Regional
house prices (change in levels) 48
3.48.   Housing
affordability by region  48
3.49.   Mortgage
approvals and house price growth  49
3.50.   House prices
and mortgage debt 49
3.51.   Market
expectations of future yields 50
3.52.   Mortgage
arrears and repossession rates 51
3.53.   Proportion of
mortgage applications approved (% balance) 52
3.54.   Housing
tenure and housing cost overburden rates 57
LIST OF Boxes
3.1.     The
Financial and Insurance services sector 20
3.2.     PNFCs -
supply and demand for credit. 35
3.3.     Sources of
funds for PNFCs 38
LIST OF Maps
No table of contents
entries found.
In April 2013, the Commission concluded
that the United Kingdom was experiencing macroeconomic imbalances, relating to
household debt, the housing market and, to a lesser extent, external
competitiveness. In the Alert Mechanism Report (AMR), published on
13 November 2013, the Commission found it useful, also taking into account
the identification of an imbalance in April, to examine further the persistence
of imbalances or their unwinding. To this end, this In-Depth Review (IDR)
provides an economic analysis of the UK economy in line with the scope of the
surveillance under the Macroeconomic Imbalance Procedure (MIP). The main
observations and findings from this analysis are:
·       Growth picked up markedly in 2013 at 1.8% compared with 0.3% in 2012
and is projected to increase further to 2.5% in 2014. Growth in the UK outstripped that in the euro area (-0.4% in 2013),
the largest export market for the UK. However, growth has been driven
predominantly by household demand and has been accompanied by a rise in the
current account deficit. In 2013, domestic demand contributed 1.6 pps. to
growth, driven mainly by an upswing in private consumption while net exports
contributed slightly to growth by 0.1 pp. A more broadly based recovery is
desirable in which both business investment and net exports contribute
positively to growth.
·       The export market share continues to decline although it has
stabilised recently and the pace of decline has fallen. Reflecting the impact of the international economic crisis,
financial services exports have fallen. Following the strong depreciation of
sterling in 2008-2009, exporters responded by raising margins instead of
increasing market share so the impact of the depreciation on export growth has
been relatively subdued. The risks associated with the declining export share
are less marked in the short term but are higher in the medium term - the
current account deficit may gradually increase over the medium term should the
export market share continue to deteriorate. Structural challenges to raising
exports include a low level of infrastructure endowment, skills gaps, in
particular, in technical areas and constrained access to finance for Small and
Medium-sized Enterprises (SMEs). Policy initiatives are being developed to
address these issues.
·       Fiscal consolidation is underway which aims to stabilise and reverse
the high general government debt ratio which
averaged around 40% of GDP in the decade before the international economic
crisis but rose swiftly to reach almost 90% of GDP in 2012-13. The budget
deficit was below 3% of GDP in 2007-08 but increased rapidly to peak at 11.4%
in 2009-10. Reflecting the impact of a substantial and necessary fiscal
consolidation, the budget deficit fell to 5.2% in 2012-13. The fiscal
consolidation is expected to continue and, as a result, the deficit is
projected to decrease further with the pace of increase in general government
indebtedness falling. The UK is currently subject to an Excessive Deficit
Procedure. 
·       Although the pace of private sector deleveraging has slowed
recently, private sector indebtedness has fallen significantly from its peak,
in particular, for private non-financial corporations (PNFCs). PNFCs' balance sheets are strong and the PNFC sector is a net
lender to the rest of the economy suggesting that the sector is resilient
despite the slowing in deleveraging; the risks posed by high PNFCs' debt are
less marked than at the time of the 2013 IDR. 
·       Household sector indebtedness, despite having declined from its
peak, remains high and continues to pose risks.
Households' debt predominantly comprises mortgages secured against houses.
Demand for houses is increasing, reflecting increased confidence, the low cost
of borrowing and easing credit constraints. The increase in supply of new
properties has, however, been muted. As a result, house prices are rising and
household mortgage indebtedness is expected to increase. In the short term, the
increase in housing supply is likely to remain below that of household
formation although the government is implementing reforms to boost the supply
of land and the stock of housing in the short and medium terms. The housing
market is marked by divergent developments in London and the rest of the UK.
In the year to November 2013, house prices increased by 5.4% largely driven by 
rises in London where prices increased by 11.6% whereas, excluding London and
the south east, house prices increased modestly by 3.1%.
·       Credit constraints are easing for households and credit supply is
rising. However, credit supply continues to fall
for PNFCs – it fell by 3.4% in the year to December 2013 – while, for
households, secured lending increased in the same period by 0.9%. There is a
need to ensure adequate access to finance for PNFCs, particularly SMEs, that
need it to invest and expand. Policies are in place to help address the issue.
This IDR analyses these imbalances and
associated risks and challenges. It considers a number of ways in which
government policy can address the challenges, minimise the risks associated
with any imbalance and prevent it from worsening. 
·       To improve external competitiveness, improvements in infrastructure,
skills, credit access for SMEs and export promotion could be considered. Firstly, transport bottlenecks and capacity shortages could be
addressed by investing in infrastructure. The UK government's National
Infrastructure Plan 2013 sets out ambitious plans to boost the quality and
quantity of national infrastructure and envisages investment of GBP 375
billion, a significant portion (around three-quarters) of which is private sector
funding; effective implementation and harnessing private sector funding is key.
Secondly, businesses require a labour force with specific intermediate and
advanced technical skills in order to expand. Gaps in this area could be
reduced by focussing on STEM (science, technology, engineering and mathematics)
skills and apprenticeships and cooperating with businesses in order to identify
the professional and technical skills required by the tradable sector. The
government published an implementation plan on apprenticeships and has
initiatives in place to raise vocational skills.  Thirdly, whilst credit
constraints have diminished, particular challenges surrounding access to credit
remain for SMEs. The establishment of the Business Bank is a positive step and
should help SMEs obtain alternative sources of finance while the refocussing of
the Funding for Lending Scheme to PNFCs only should help all PNFCs including
SMEs. Fourthly, exports could be stimulated by providing export credit where
constraints exist. Finally, facilitating the recruitment of foreign experts
could improve external mobility and ability to engage in international trade.
·       To minimise the risks associated with rising house prices and high
household indebtedness, there is a need to address the short and medium term
imbalance between supply and demand for property. A
number of useful policy initiatives are being implemented but there is scope
for further action. In relation to demand, at a time in which credit
constraints are easing in the mortgage market, the need for the Help to Buy 2
policy may diminish. Close monitoring of credit availability and associated
macroeconomic developments is required given the risks associated with Help to
Buy 2 and the policy could be scaled back – and/or more closely targeted –
should credit supply growth rise further and credit constraints continue to
ease. In relation to macro-prudential regulation of credit conditions in the
housing sector, there is a case for a more detailed public assessment by the
Financial Policy Committee of the Bank of England of the merits of the various
instruments available to it and the situations in which they would be deployed
to increase markets' knowledge of its approach to regulation. In relation to
supply, there is scope to consider the development of appropriate and targeted
incentives for local authorities to release land with planning permission
attached for development in the context of local solutions to inadequate
supply. Local solutions may also include the taxation of vacant property. In
relation to taxation, revaluation of the property roll would reduce distortions
in the taxation system in favour of owner-occupied housing.
On 13 November 2013, the European
Commission presented its third 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 in the sense of the
legislation and what type of follow-up in terms it will recommend to the
Council.
This is the third IDR for the United
Kingdom. The previous IDR was published on 10 April 2013 on the basis of which
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. Overall, in the AMR, 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 provides an economic analysis of the UK
economy in line with the scope of the surveillance under the Macroeconomic
Imbalance Procedure (MIP).
Section 2 provides an overview of general
macroeconomic developments, section 3 considers the main imbalances and risks,
including on export share, private indebtedness and the housing sector and
section 4 discusses policy considerations.
Growth and inflation
The recovery since the international
economic crisis had been slow and protracted until 2013. However, 2013 finally saw a decisive shift towards a more sustained
recovery in which growth reached 1.8%. The main source of growth was domestic
demand, particularly private consumption. Net exports detracted from growth in
2012 but made a small positive contribution in 2013.  Despite the pick up in
growth in 2013, the economy remains 1.4% below the pre-crisis peak. Growth is
projected to rise further in 2014 to 2.5%, stabilise somewhat thereafter and
broaden as growth gross fixed capital formation increases and  the contribution
to growth from net exports becomes positive but remains small (Graph 2.1).
Inflation has been on a downward
trajectory since September 2011 when it peaked at a
5.2%. Following some stickiness in the twelve months from October 2012 in which
inflation averaged 2.7%, the rate has fallen more quickly in recent months to
1.9% in January 2014. The recent decline can be attributed to a fall in oil
prices, delayed rises in utility charge increases and lower-than-expected
increases in education costs. Inflation is expected to remain around the Bank
of England’s 2% target.
Unemployment and poverty
The unemployment rate peaked at 8.4% in
the final quarter of 2011 and has fallen consistently since then. In the final quarter of 2013, the unemployment rate was 7.2%. 
The fall in the unemployment rate has occurred as strong rises in private
sector employment have outweighed reductions in public sector employment.
Between the third quarter of 2009 and the same quarter in 2013, public sector
employment has fallen by some 10.6% ([1]). However, the improvements in employment have been accompanied by
stagnant/ declining levels of productivity.
The regions with the highest
unemployment rates in England are the North East and West Midlands and the rate increased in those regions in 2013. The lowest rates
are in the East of England, and are falling, thereby contributing to an
inter-regional division ([2]).
Youth unemployment has increased over
the past ten years and reached 21% in 2012 (Graph
2.2) ([3]).
Furthermore, almost one-third of youth have been unemployed for more than one
year. Long-term unemployment has increased over the past decade and reached
2.7% in 2012 ([4]). Poverty
indicators provide a mixed picture as the severe material deprivation rate rose
from 2008 to 2012 (the date of the last available data) ([5]); however, the at-risk of poverty or social exclusion rate has
declined since 2005 and is now below the pre-crisis level.
Potential growth
In 2014, potential growth is projected
at 1%([6]), around
one-half of the level just prior to the crisis. Low
potential growth reflects low productivity growth and the combination of a
resilient labour market and growth in employment that outstripped that in GDP.
Low productivity is likely to reflect a combination of factors such as the
lower price of labour relative to capital leading to a rise in demand for
labour, albeit possibly less productive labour, a rise in employment in less
productive sectors of the economy and forbearance and cheap credit allowing
some firms to remain in the market from which they would otherwise have exited.
In 2012, the Greater South East (London,
the South East and East of England regions) contributed 45.4% of total Gross
Value Added (GVA). This was an increase from 44.3% in 2007 and 43.1% in 2001.
London alone accounted for 22.4% of GVA in 2012 and grew by 2.0% over the year;
higher than the UK average of 1.6%.
The external side 
Although the deterioration in export
market share reversed in 2013, net exports only contributed 0.1pp to growth. The trade balance for services has been improving recently although
the goods balance has been deteriorating. Exports are reorienting towards non
EU markets but the EU still accounts for the largest export share by
destination. In 2012, the single largest destination for exports was the US
(13.7% of total exports), followed by Germany (10.6%) whereas China accounted
for 3.5% of total exports. Growth in net exports is projected to remain subdued
in 2014 in part reflecting relatively subdued growth in the euro area.
Along with weak export growth, there has
been a sharp deterioration in earnings on overseas investments. In 2013, the current account balance reached a deficit of 3.8% of
GDP.
The fiscal position
Fiscal consolidation has been underway
since the June 2010 Budget. This has resulted in a
6.2 pp. fall in the budget deficit to 5.2% of GDP in 2012-13. The
consolidation has been assisted by certain one-off items which account for
approximately one-third of the decline. Furthermore, the ongoing transfers from
the Bank of England’s Asset Purchase Facility also contributed to the decline ([7]). Gross government debt continues to increase and reached 88.1% of
GDP in 2012-13.
Private sector debt 
Private sector debt peaked at 195% of
GDP in 2009 and has been declining since then although it remains high (Graph
2.3). Household debt and corporate debt both remain
high despite having declined since 2009 and the pace of decline has fallen. The
household savings ratio was high in 2012 but fell somewhat in 2013.  
During 2013, activity in the housing
market increased with prices rising from an already elevated level. The strongest rises were in London and the South East.
The financial sector and credit
Credit conditions have been improving
for households although the supply of credit remains muted for corporates (Graph 2.4). According to the Bank of England’s Credit Conditions
Survey([8]), the overall
availability of credit for both small and large corporates increased
significantly in the final quarter of 2013. This was the fifth consecutive
quarter of increases. Secured credit to households also rose including for
borrowers with high loan-to-value ratios. This trend may have been affected by the
Help to Buy scheme. However, despite positive signs from surveys, overall
credit growth remains low and continues to decline for corporates. 
A number of government policies have
been designed to improve the flow of credit in the economy, in particular, the Funding for Lending scheme (FLS) and
quantitative easing (QE). The FLS was introduced in July 2012 and was extended
by one year in April 2013; however, in November 2013, the terms of the lending
were changed, effective from 1 January 2014, by excluding lending to households
and focussing solely on corporate lending. As part of QE, between March 2009
and July 2012, the Bank of England purchased GBP 375 billion worth of
government bonds but has not returned to the market since then.
The government is establishing a
Business Bank which should be operational by the
second half of 2014. The Bank aims to assist SMEs to obtain alternative sources
of funds. 
Throughout 2013, the eight major banks
and building societies continued to eradicate capital shortfalls based on the
Prudential Regulation Authority's (PRA) recommendations of March 2013. By September, three-quarters of the shortfalls had been addressed
in the banks in which issues had been identified. This represented a
1.5 pp. improvement in their capital ratios. Banks that were not
identified as having a shortfall also took actions which raised their capital
ratios by 0.5 pp. in aggregate. The Bank of England and the PRA are also
developing a regular stress-testing framework to assess the resilience of the
banking system to housing-related portfolios, among others, with the first
tests to be carried out in 2014. Furthermore, stronger mortgage underwriting
standards will be implemented in the context of the Mortgage Market Review
from April 2014.
3.1.      Export
Share and Competitiveness
The 2013 IDR described the external
dimension of the UK economy as "less as a source of macroeconomic
instability, and more a field of often underexploited growth
possibilities". The reasons for the
deterioration in the export share were analysed in the 2012 and 2013 IDRs. This
IDR sets out an update of developments in the current account balance and
export share and examines the role of government policy in addressing potential
bottlenecks to export growth including in relation to infrastructure, access to
finance and skills. 
3.1.1.   The
current account deficit
The UK has registered persistent current
account deficits since the late 1990s and stood at
3.8% of GDP in 2013. For more than 15 years, the current account balance showed
a consistent trend - a negative and increasing goods balance goods and, while
slightly smaller, a positive and increasing services balance (Graph 3.1).
However, both have flattened recently. The trade deficit increased steadily
over most of the past 15 years although it too has stabilised in the last few
years. In 2013, the trade deficit in goods is projected to have reached almost
7% of GDP while the surplus in services stood at almost 5% of GDP. 
The deterioration in the current account
balance following the international economic crisis was dominated by movements
in the income balance. Historically, the income
balance has been in surplus but has recently moved into deficit and contributed
to the rise in the current account deficit. The deterioration appears to be
mostly driven by differential returns between inward and outward investment of
the UK. Notably, the UK has been growing at a faster pace than the EU - its
most important trading partner and investment destination (the EU absorbs about
half of the UK's exports and accounts for approximately 40% of its inward
investment). As a consequence, profits earned by UK companies on investments
abroad may have developed less favourably than those of inward investment. A
recovery in net investment income in 2014 is projected, which should – if sustained
over the medium term - contribute to a narrowing of the deficit ([9]). 
The pattern of recent economic growth in
the UK compared with its major trading partners might explain part of the
deterioration in the trade balance. Since the end
of 2009, growth has been driven by growth in domestic demand rather than net
exports (as discussed in Chapter 2). Recently, growth in the UK has outstripped
that in the euro area – for example, the UK grew by 1.8% in 2013 compared with
-0.4% for the euro area – which may have affected relative import and export
growth to the detriment of the trade balance. As domestic demand picks up
further, imports are likely to increase further which is likely to result in a
further deterioration in the trade balance should growth in imports continue to
outstrip growth in exports.  Nevertheless, relative losses in export market
share stabilised in 2012 and 2013 (Graph 3.2).
 
The deterioration in the current account
deficit may be associated with movements in gross savings and investment (Graph 3.3). Since the international economic
crisis, domestic demand has been sustained by a substantial decline in the
national savings rate. Gross national savings have fallen sharply from 16% of
GDP in 2008 to 10% of GDP in 2013 and have been accompanied by a fall in
investment from over 17% of GDP before the crisis to below 14% of GDP. Neither
the fall in investment nor the deterioration in the current account is
consistent with balanced medium-term growth. 
The prospect of a more balanced pattern
of growth depends on a shift in the composition of growth towards exports and
investment. Despite rising recently, the current
account deficit is associated with a modestly negative net investment position
of -9% of GDP in 2012 and zero in 2013. Furthermore, these developments need to
be seen in the context of a floating exchange rate, which facilitates external
adjustment. 
However, if the current pattern of
growth is to become more balanced, growth in investment and net exports need to
rise to complement growth in household consumption so that balanced growth is
accompanied by a fall in the current account deficit and an increase in the net
savings rate in the order of a significant 7% of GDP. To achieve this feat in a growing economy, improved external
performance plays a crucial a role. Rebalancing away from domestic demand
towards net exports would be also consistent with an increase in savings and
investment.
The medium-term prospects for net
exports need to be analysed in the context of several potential adverse
developments which include: the loss in export
market share, especially for services exports, the long-term decline in goods
exports, the muted response of exports in the wake of the substantial
depreciation of sterling and the fall in financial services exports since the
start of the international economic crisis.
3.1.2.   Export
shares challenge 
In the five years to 2012, the UK lost
approximately 20% of its export market share in goods and services although the
pace of decline slackened in 2012. There is not a
single obvious driver of the decline in export shares. Rather, it is determined
by a number of factors including weakness in exports of financial services,
itself reflecting broader weakness in the financial sector, and the mix of
destinations and product markets for export. Other factors may include impaired
access to finance for exporters and long-standing issues relating to the
quality and quantity of infrastructure and skills.
Despite the relative strength in exports of
services (contributing 4.5pp of GDP to the current account balance in 2012),
the UK's world market share for services decreased from 7.9% in 2000-2001 to
6.6% in 2010-2011. A breakdown by industry shows an across-the-board decline in
most sectors over the past ten years (Graph 3.4), including, in particular, a decrease
in the world market share of the financial and insurance services industries
(see Box 3.1).
The persistence of a deficit in the goods
trade balance reflects deep-rooted characteristics of the economy. The trade balance is marked by a structural shift toward services
and increased competition from emerging markets for goods exports. The weakness
in certain goods exports is also linked to intense competition in export
destinations. A decomposition of the nominal growth of goods exports by
geographical specialisation and product specialisation (Graph 3.5) shows that, between 2006 and 2008, the
decline of market share was driven mainly by the loss of market share within
existing destinations and product markets rather than the 'dynamism' ([10]) of such destinations and markets ([11]). 
More recently – between 2010 and 2012 - the
UK gained market share in its export destinations, which, however, are losing
'dynamism'. Graph 3.6 shows the relationship, in the top-10
destinations for UK goods exports, between the growth in imports of these
countries (market dynamism on the vertical axis) and the extent to which
exports are growing in these countries (competitiveness on the horizontal
axis) ([12]). The graph
shows that the UK's top export destinations are disproportionally represented
in the bottom-left quadrant of the graph, which means that - except for
Switzerland and China – they are either losing dynamism or the UK is losing
share in those countries compared to other export competitors. 
Over the medium term, geographical
specialisation might diversify continuing a
rebalancing away from the EU to emerging markets (Graph 3.7). While the EU is still the main export
destination for goods, accounting for half the trade in value, the share of
BRICs in total exports has grown from 4.9% in 2006 to 9.6% in 2012. 
3.1.3.   The
impact of the depreciation 
Sterling fell significantly vis à vis
the euro between 2007 and 2009. It is now at a mean
of approximately 1.2 euro from a 4-year pre-crisis average of almost 1.5 euro
(Graph 3.8). The depreciation could be expected to
improve external competitiveness and the current account balance, the impact on
the latter by boosting exports – which become cheaper for foreign purchasers –
and deterring imports – which become more expensive for domestic purchasers -
however, there may be circumstances in which a depreciation is less effective
than expected ([13]).
Export growth may have responded by less
than expected to the fall in the exchange rate because, following the
depreciation, prices may have risen relative to those of foreign competitors,
thus eroding the competitive advantage that may normally be expected. It is noteworthy that the export price deflator has risen by more
than that of the Euro 15 (Graph 3.9).  
The strong nominal depreciation in 2008
is matched by a marked fall in the real effective exchange rate (REER) (Graph 3.10) (a standard measure of
competitiveness). The close relationship between the REER and the nominal
effective exchange rate (Graph 3.11) reflects the relatively small impact of
relative inflation to changes in competitiveness since the depreciation in 2008.

Since 2008, the sizeable depreciation
has not had a significant relative impact on export growth or the contribution
to growth from net exports. Although goods exports
grew between the trough in 2009 and 2013 by 21% - broadly in line with that in
the EU 15 of 24% - services' exports remain relatively subdued, growing in real
terms by 7% compared with that in the EU 15 of 14%.
It is likely to be the case that
exporters have responded to the depreciation by increasing margins rather than
significantly expanding output (Graph 3.9). In addition, nominal unit labour costs
have risen consistently since 2008 (Graph 3.12) as growth in nominal compensation has
continued, albeit at a subdued rate, but labour productivity has fallen.
A sectoral assessment suggests that,
between 2009 and 2011, firms in the tradable sectors, specifically in the
manufacturing sector, may have benefited from the depreciation of sterling (Graphs 3.13a and b) ([14]). Higher margins may have improved the relative profitability of
tradables compared to non tradables which might provide incentives to firms in
the tradable sector to allocate more resources in the production process. In
the pre-crisis period, profitability in the non tradables (in particular
construction and real estate) did not rise above that of other sectors, as it
did in certain other large EU Member States (Graph 3.13a).
 
However, increased profitability has not
resulted in a significant increase in exports as discussed above. It may also be the case that demand from major trading partners
for exports fell during the international economic crisis – although that
impact should unwind as the crisis recedes. In addition, the price elasticity
of demand for high value exports is likely to be low because demand may depend
on non price as well as price characteristics. In addition, resource allocation
towards the export sector could also be affected by uncertainty as to whether
the fall in the exchange rate is temporary or permanent – although this effect
should have receded by now ([15]). 
Government policy can play a role in
improving the environment in which exporters operate, facilitating rebalancing
over the medium term. As noted above, productivity
has declined since 2009. Government policy may help address bottlenecks to
exports as discussed in the following subsection by helping to raise
productivity and competitiveness.
3.1.4.   Policy
responses: Infrastructure, skills and SME finance 
Previous IDRs identified structural
constraints in infrastructure, skills and access to finance that might affect
export performance - especially for SMEs. There are
policies in place to address these bottlenecks. Moreover, the government has an
ambitious objective to "double the UK’s exports to GBP 1 trillion by 2020
and a program to attract more inward investment in UK infrastructure
projects" ([16]). However,
there are challenges relating to detail and delivery. 
Infrastructure 
Investment in infrastructure is below
the EU average ([17]). Investment in transport infrastructure are particularly relevant
(Graph 3.14) - in the last decade, the UK has
invested less in transport infrastructure as share of GDP than the EU27 average
and countries - such as France and Belgium – which, like the UK, have a mature
transport network. Moreover, the investment share in GDP has fallen over time,
similar to the trend in Germany, but the fall has become more pronounced since
2009. In an advanced economy, adequate investment in infrastructure – while not
sufficient in itself – may be a pre-condition to enhancing export performance;
recent research indicates a positive association between domestic transport
infrastructure improvements and small and medium-sized firms' probability of
exporting ([18]).
There are also concerns about the
quality of the infrastructure. A survey by the
World Economic Forum shows a relatively low assessment of the quality of
infrastructure in the UK, as well as a relatively low assessment of the quality
of roads. Perceptions from abroad about the quality of infrastructure are,
however, mixed. For example, according to a survey of foreign-based companies ([19]), 81% of respondents acknowledged transport and logistic
infrastructure as a good reason to invest in the UK and 89% of respondents praised
technology and telecommunications infrastructure – which is consistent with the
fact that the UK has an above EU average percentage of broadband lines with
speed above 10 MBps ([20]). 
London's economic success risks
exacerbating the regional divide within the UK. A
large rail project, High Speed 2, initially planned to run between London and
Birmingham, has the potential to change regional dynamics but its potential
impact is ambiguous: on the one hand it will make London easier to reach and
thus increase the attractiveness of siting business in London but, on the other
hand, it will allow easier access to Birmingham and other regional centres from
London. A further option to enhance growth outside London could be to enhance
connectivity between cities in northern England (Manchester, Newcastle,
Liverpool), as well as between different parts of the UK.
The government has announced an
ambitious infrastructure program and has published a 'pipeline' of
infrastructure investment worth GBP 375 billion between 2015 and 2020 ([21]). GBP 100 billion of infrastructure
investment is expected to be funded publicly while the remaining GBP 275 is
expected to be raised from private funds – for instance a group of large
insurance companies has agreed to invest GBP 25 billion in the 5 years from
2014 ([22]). The
National Audit Office ([23]) has,
however, expressed concerns about how the private financing might impact on
consumers , who will eventually be charged higher tariffs, especially
those on low incomes. Most of the value of the pipeline is in the energy and
transport sectors, worth over GBP 340 billion of combined investment. 
There are inherent risks in the private
sector element of the financing – which accounts for around three-quarters of
the total financing; in particular, the degree and timelines in which the
private financing will materialise. While anecdotal
evidence suggests that investment in infrastructure could be considered
attractive by institutional investors, and that business networks may welcome
even larger investment plans, greater detail and clarity is required on the
composition of the private financing and reassurance that the required amount
of that finance will materialise. 
Potential investors in infrastructure
include international investors (e.g. sovereign wealth funds) and domestic
investors (pension funds). The Pensions Institute
has forecast that the defined contribution pension schemes’ auto-enrolment
market will increase to GBP 1680 billion ([24]) of assets under management by 2030. The extent to which those
assets will be invested in infrastructure is linked to the concentration of
pension funds, as in an overly fragmented market, individual funds might lack
scale for such large investments. A solution may be provided by platforms that
pool the resources of more pension funds for infrastructure investment – such
as one recently announced by the National Association of Pension Funds ([25]). Nevertheless, there remains a need for greater detail on the
infrastructure investment plans in relation to the source, composition and
timing of funds 
Further risks to delivery of the
infrastructure programme include alleged uncertainty in the regulatory
environment – for example - the Confederation of
British Industry’s infrastructure survey ([26]) identified planning as the biggest constraint (96%) for
infrastructure investment. The fact that the delivery of the projects is spread
over a number of years is a further element of risk.
Skills and job matching
The 2012 and 2013 IDRs identified a gap
in skills, in particular, there are an insufficient
number of workers with intermediate vocational training. While the skills base
is strong overall, there is room for improvement in basic and intermediate
skills. It is noteworthy that, compared to the EU average, the UK has a larger
number of early leavers from education and training. 
International comparisons ([27]) also show a relative underperformance in attainment in basic
skills and foreign languages. Although English is
the global language of business, knowledge of foreign languages by UK citizens
could increase their ability to participate in international trade and boost
international mobility; to eventually facilitate this, it is a positive
development that language classes in schools will be made compulsory ([28]) for pupils from the age of 7 in England. 
On the positive side, employers are
generally satisfied with skills availability ([29]). The UK has a high share of adults
between 30 and 34 of age with tertiary educational attainment ([30]) and a relatively high employment rate of graduates. Higher
education provides additional reasons to be optimistic: universities are
internationally renowned and could be a driver of regional rebalancing. In
fact, the creation of clusters of firms which exploit the specialisations of
universities outside London could create attractive jobs in different cities
and counteract the centripetal force that brings graduates to London. 
The demand for skilled labour is likely
to increase as soon the economy recovers. This
would be a positive development for the economy, as, according to OECD, the
UK ([31]) has been
more effective in providing opportunities to their more highly skilled adults
than many other countries.
 Nevertheless, the problem of the
vertical skills mismatch in the UK might have worsened after 2008. While
graduates usually do well in the labour market, according to the Office for
National Statistics, the percentage of graduates working in non graduate roles
has risen, particularly since the 2008-2009 recession. This suggests that the
increasing supply of graduates and the possible decrease in demand for them has
had an effect on the type of job they undertake ([32]). Since new graduates could not be absorbed into the labour market
to the same extent as previously, some may have to 'down-skill'. To address the
situation, promotion of STEM subjects (science, technology, engineering and
mathematics) in higher education may assist. 
Job matching efficiency has recently
worsened, in particular, for long-term unemployed.
This is suggested by the Beveridge curve, which depicts the relationship
between unemployment and job vacancies. The curve is usually downward-sloping:
economic upswings are characterised by low unemployment and many vacancies and
vice versa in downturns. Shifts of the curve are departures from the usual
downward-sloping trajectory and may indicate structural changes in the labour
market. An outward shift of the Beveridge curve is an indication of a
deterioration of job market matching. 
The Beveridge curve showed little
movement in the years before 2008 (Graph 3.15a) ([33]) which can be explained by the fact that the economy then operated
at high factor utilisation, low unemployment and a relatively high vacancy rate
(the number of vacant posts as a percentage of total posts, vacant or
occupied). As the international economic crisis unfolded, vacancies fell and
unemployment increased to levels where it remained until the last quarter of
2012, the last observation available. 
A large majority of unemployment is
short-term (shorter than 12 months in duration).
Graph 3.15b depicts the post-crisis Beveridge
curve in the UK by duration of unemployment ([34]). It shows that the short- and long-term Beveridge curves have a
different pattern. The Beveridge curve corresponding to short-term unemployment
is characterised by the usual downward-sloping pattern. By contrast, the
Beveridge curve corresponding to long-term unemployment exhibits an outward
shift of about 1 percentage point in 2009-2010, presumably about 12 months
after the first wave of dismissals during the crisis), and did not increase further
after 2010. It appears that a large part of unemployment remains cyclical, and
a smaller, albeit rising, part potentially structural (Graph 3.15b). Short-term unemployment could be
expected to decrease as the economy moves along the short-term Beveridge curve.
The government intends to address the
shortage of intermediate skills. The government
published "The Future of Apprenticeships in England: Implementation
Plan" in October 2013 ([35]). This was a response to the 2012 Richard Review ([36]), an independent report on improving the quality of
apprenticeships. Apprenticeships are to be based on standards designed by
employers in order to better meet the needs of the economy. These standards,
which will replace the current frameworks, aim to simplify the system. In
relation to quality assurance, the government will set a small number of
criteria: apprenticeships will be required to last at least 12 months;
off-the-job training will continue to be a requirement of all apprenticeships
and English and maths requirements will be stepped up gradually. Implementation
will be completed by 2017-18. 
Compared to that in 2011-12, the number
of apprenticeship starts at advanced level and higher level has increased, while apprenticeship starts at intermediate level decreased. This
may be a first sign of a rebalancing of apprenticeships towards higher skill
levels. Ongoing reforms of vocational qualifications are also part of the
effort to increase vocational skills among young people and adults. 
Policy initiatives to raise vocational
skills are likely to be beneficial if maintained, or even stepped up. Indeed, skills forecast expect an increased demand for medium
qualifications in the UK. CEDEFOP, the European Centre for the Development of
Vocational Training, estimated projections about employment trends by
qualification up to 2020. Compared with 2010, it expects an 17.8% increase in
jobs requiring medium qualifications in the UK, much higher than an EU average
increase of 4.6%; a 20.6% increase in jobs requiring high qualifications,
broadly in line with an EU average increase of 19.1%; and a 42.9% decrease in
jobs requiring low qualifications, which is more pronounced than an EU average
decrease of 20.2%.
The effectiveness of policy responses to
skills shortages can be improved. According to the
Social Mobility and Child Poverty Commission, the Youth Contract has not worked
"effectively enough" ([37]). There is anecdotal evidence that business associations are
supportive of apprenticeships, provided that they are of high quality and
targeted at certifying relevant work experience and skills. 
Work is underway to increase the
attractiveness of vocational education as an alternative career path, as currently there might be 'stigma' attached to it, perhaps
because of better perceptions attached to academic education. The key to the
success of these policies is productive cooperation with employers in the
design and development of occupational standards and skills profiles to make
vocational qualifications more attuned to labour market needs ([38]). As young people are "not much better equipped with literacy
and numeracy skills than those who are retiring" ([39]), there is also scope for thinking strategically about the role of
lifelong learning.
Fine-tuning of immigration policies has
the potential to broaden the skills base of the UK.
It would make it easier to recruit experts from new export destinations and UK
employers would have access to a larger pool of talent ([40]).
Access to finance for SMEs
International comparisons suggest that
UK SMEs have a lower export propensity than EU peers ([41]). According
to a recent survey ([42]), only a
minority of SMEs (14%) were internationally active. Of all survey respondents,
8% reported having exported while 11% reported having imported in the third
quarter of 2013. 
A constraint on the decision of SMEs to
export may be an inability to easily obtain access to external finance. SMEs can potentially benefit from the significant depreciation of
sterling that took place since 2008. However, difficulties accessing finance,
particularly credit, and/or accessing it on competitive terms, may constrain
SMEs' ability to expand and access export markets ([43]). It may also affect their ability to compete internationally by
constraining productivity ([44]).
The ability of SMEs to raise external
finance appears to have been impaired during the global financial crisis and
subsequent UK recession. As discussed in Box 3.3,
PNFCs as a whole were excessively reliant on credit as a source of finance in the
lead-up to the international economic crisis and recession in the UK and have
been adversely affected by the continuing decline in bank credit, not least
because they have been unable to obtain external finance by alternative means.
The reliance on external credit to expand is likely to be a particular issue
for SMEs which can lack the size or sophistication to issue fixed-interest debt
and equity or seek other means of external finance and are mostly reliant on
bank credit to raise funds. 
Neither credit available to SMEs nor
their perceptions of their ability to access credit have improved significantly
since the 2013 IDR. Net lending to PNFCs, and to
SMEs in particular, continued to decline in 2013 (Graph 3.16). In addition, surveys of SMEs continue
to show that access to finance on suitable terms remains a concern. According
to BDRC Continental's SME Finance Monitor, more than a third of SMEs applying
for a loan did not manage to obtain the desired facility either because they
were turned down or because of other issues with the 'offer' ([45]). Additionally, 17% of applicants managed to obtain funding only
after going through issues with the offer. Another recent survey carried out by
the Federation of Small Businesses in the fourth quarter of 2013 showed that
approximately four in 10 ten SMEs applying for loan had been unsuccessful ([46]). These comparatively high loan rejection rates have been a
persistent characteristic of the post-crisis period in the UK ([47]). A recent report to the UK government ([48]) estimated a funding gap for SMEs of GBP 8.2-12.6 billion in 2012.
The size of the gap was split reasonably equally between 'loan rejections' and
'discouraged demand' (that is, SMEs that did not consider it worthwhile to
apply for a bank loan to begin with). Finally, bank lending to SMEs is
relatively concentrated which may render them particularly dependent on the
relationship established with their own bank (see Section 3.1.12).
Not only does credit supply remain
constrained, the cost of credit is comparatively high for SMEs. Survey evidence suggests that borrowing cost developments since
2009 have been more unfavourable for smaller companies than for larger ones
(Graph 3.17). Although the cost of borrowing
declined when the Bank of England cut its reference rate to 0.5% in 2008,
margins have risen, particularly for smaller SMEs (Graph 3.18). The relatively high margins may be
partly explained by the risk characteristics of SMEs but, nevertheless, may
remain a deterrent to SMEs requiring cost-effective finance in order to expand.
The government has responded to concerns
surrounding SME access to finance with a number of measures. These include inter alia, the Funding for Lending Scheme
designed to boost credit availability and reduce the cost of borrowing for
firms, including SMEs; the proposed Business Bank, to provide alternative
sources of finance to SMEs. (These measures are discussed in the following
section.) While a number of access to finance policies have been in place for a
significant period of time, they nevertheless have yet to exert a marked impact
on SMEs' credit conditions. 
3.1.5.   Conclusions
The UK's export share in world exports
continues to decline but the pace is less rapid than in previous years. This continues the pattern of gradual but persistent decline of the
past decade. There is no apparent single reason to explain the decline; rather,
it is likely to be the outcome of a number of smaller factors and wider issues
relating to the structure of exports and its export markets. Such trends need
to be interpreted in the context of the rising share of emerging markets in
world trade. 
Government policies could support a
rebalancing towards net exports. For example, the
effective delivery of the announced 'pipeline' of infrastructure investment has
potential to remove bottlenecks and boost export performance. In addition, the
focus on apprenticeships is likely to raise skills provided that the quality of
the apprenticeships is high. The authorities could also continue to monitor the
impact of credit access and export finance policies and extend them if
necessary. 
Overall, the declining export share is
unlikely to pose short-term risks to the economy.
However, in the absence of a major change in the structure of exports or export
markets, or government policy to support rebalancing, the export share is
likely to continue to slowly deteriorate over the medium term. In turn, the
main risk associated with a slow deterioration of the export share is, other factors
held constant, an associated deterioration, over the medium term, of the
current account deficit and the net international investment position.
3.2.      Private
Sector Indebtedness 
3.2.1.   Introduction
High private sector indebtedness was
identified as a macroeconomic imbalance in the IDRs in 2012 and 2013 and has
been identified again as a potential imbalance in 2014. This section analyses: recent trends and developments in private
sector indebtedness, risks associated with high levels of private sector indebtedness,
particularly for Private Non-Financial Corporations (PNFCs), the need to
maintain adequate access to finance, especially for SMEs while orderly
deleveraging continues, the impact of government policy in facilitating
sufficient access to credit and sets out conclusions on the state of any
imbalance and the risks associated with it.
Developments in the housing market and
household sector indebtedness have been particularly marked over the past year and have potential implications for the existence of, and risks
surrounding, any macroeconomic imbalance and are analysed separately in Section
3.3. 
3.2.2.   Trends
and developments
Size of deleveraging
After having increased steadily during
the previous decade, private sector indebtedness has peaked at 195% of GDP ([49]) in 2009 (Graph 3.19). Since then, private sector
indebtedness has fallen to 179% of GDP in 2012 reflecting deleveraging by
households and PNFCs as the size of the economy grew in nominal terms. However,
the pace of reduction in indebtedness declined in 2012 – as minimal economic
growth was matched by a small fall in debt holdings.
Private sector indebtedness is, broadly,
split equally between indebtedness of households and PNFCs (Graph 3.19) and the pace at which both sectors
reduced holdings of debt fell in 2012:
·       for PNFCs', debt as a % of GDP has fallen since its peak in 2009 but
the pace of decline lessened in 2012 as PNFCs' debt began to stabilise at a
relatively high level; and
·       for households, debt as a % of GDP has also fallen since its peak in
2009 and the pace of decline lessened in 2012 as debt also began to potentially
stabilise at a relatively high level.
Despite recent falls, the current level of
private sector indebtedness remains historically high.
Alternative measures of indebtedness
corroborate the slowdown in deleveraging by the corporate sector: PNFCs' debt as a % of gross operating surplus has fallen from the
peak of 2009, although the pace of decline slowed in 2012 (Graph 3.20) and corporate debt as a % of financial
assets and corporate debt as a % of total assets (or gross wealth) have also
fallen but the decline has slowed more recently (Graph 3.21).
The pace of deleveraging by the
household sector has also slowed. Trends in
household debt as a percentage of financial assets and household debt as a
percentage of total assets (or gross wealth) indicate that household
deleveraging has slowed recently and that it has plateaued at a relatively high
level (Graph 3.22).
Composition of deleveraging
The composition of deleveraging since
2008 has differed between households and PNFCs
(Graph 3.23). For PNFCs it has been achieved,
predominantly, by reductions in gross borrowing and, to a lesser extent, write
offs on loans. By contrast, for households, the greatest contribution to
deleveraging has been a rise in nominal disposable income – a relatively minor
role has been played by write offs and, in absolute terms, the level of
borrowing has actually increased. 
Broadly, there are five possible drivers
of deleveraging ([50]): increased economic growth, increased saving, increases in
inflation, 'financial repression' and debt restructuring. The preferred option
to facilitate deleveraging is an increase in GDP growth. However, this has not,
to date, been the predominant route by which PNFCs have deleveraged ([51]) – rather, deleveraging has been achieved largely through a
reduction in borrowing - and, therefore, may have impacted adversely upon
future economic growth by more than would have been the case if it had been
achieved through, for example, an increase in gross operating surplus. It may
also explain the subdued performance of business investment vis a vis
household consumption (Graph 3.25).
During deleveraging, households'
consumption rose less than disposable income. As a
result the household saving ratio rose (Graph 3.24). In 2012 and 2013 the gap between the
two narrowed somewhat as the saving ratio stabilised (Graph 3.25). For PNFCs, the pattern has been
different: gross operating surplus has risen only slightly while business
investment has fallen sharply.
3.2.3.   Credit
supply
The stalling in the pace of deleveraging
has been accompanied by divergent trends in credit supply. The experience of households and PNFCs noticeably differs:
increases in credit supply to the household sector increased in late 2012 –
and, in particular, growth in unsecured credit has been relatively brisk - and
grew further in 2013 but credit supply to PNFCs continued to decline throughout
this period (although the pace of decline slackened). For PNFCs, credit supply
has fallen more heavily for SMEs than for PNFCs overall (Graph 3.26). 
The reasons for the significant rise in
growth of household unsecured credit may reflect increases of purchases of
large items such as cars. More broadly, growth in
demand for unsecured credit may reflect the boost in economic sentiment and
confidence associated with the return to growth. For example, consumer
confidence as measured by the GfK Survey has picked up steadily throughout 2012
and 2013 ([52]) (Graph 3.27), amidst rise in expected income growth
and a loosening of credit conditions so that unsecured credit is more easily
available than in the previous three years.
 (Continued on the next page) 
 Box (continued) 
 
The reasons for the divergence in credit
growth between SMEs and PNFCs as a whole may relate to certain characteristics
of SMEs. This issue is considered in more detail in
Section 3.1. However, credit supply for all PNFCs continues to decline. Factors
that may have influenced the demand and supply of/for credit over 2009-13 are
discussed further in Box 3.2.
3.2.4.   Cost
of credit
The cost of credit for PNFCs remained
low in 2013. Having fallen steeply in late 2008 and
2009 - coinciding with the reduction in the bank rate to 0.5 pps. - the cost of
credit for PNFCs remained at historic low levels throughout 2013 as shown in
Graphs 3.17 and 3.28.
3.2.5.   Near-term
outlook for credit supply and demand
Recent survey results present a mildly
positive picture for corporate credit supply and demand ([53]):
·       corporate credit availability increased significantly in Q4 2013 for
small PNFCs and large PNFCs, although it was muted for medium-sized PNFCs, and
a further improvement is expected in Q1 2014; and
·       demand for corporate credit picked up further in Q4 2013 for medium
and large PNFCs although it was subdued for small PNFCs, and a further
improvement is expected in Q1 2014 for small and large PNFCs.
3.2.6.   Risks 
Inadequate access to funds 
Adequate access to funds is important if
PNFCs are to take full advantage of the projected increase in growth in 2014 ([54]) to expand and/or increase investment ([55]). Moreover, sufficient access to credit
during a period of deleveraging can help ensure that such deleveraging is
smooth and orderly ([56]). The
potentially adverse impact of deleveraging on growth and stability can be
mitigated if credit supply remains healthy. 
Since the advent of the international
economic crisis, the supply of funds available to – and raised by - PNFCs has
fallen sharply. Prior to the international economic
crisis PNFCs were disproportionately reliant on credit to raise funds (Box
3.3). Since the crisis, PNFCs have been unable to seek alternative sources of
funds in large quantities – and to the extent that they have raised funds, it
has been largely via equity issuance although larger PNFCs have raised funds
via bond issuance. As has been discussed in previous IDRs, PNFCs', and
particularly SMEs', access to credit was adversely affected by the weakness in
the banking sector as, in response to the international economic and financial
crisis and UK recession, banks reduced the size of their balance sheets,
lowered lending to PNFCs and reduced risk as they addressed capital shortfalls
and strengthened capitalisation ratios.
According to the 'Breedon Report' (2012)
([57]), between
2012 and 2016 the projected 'financing gap' for PNFCs could range from GBP
84-191 billion depending on GDP growth and its relationship to credit supply. A continuing inability to raise funds, through credit or alternative
means, is a risk for PNFCs – particularly SMEs (SMEs' access to finance is
considered in more detail in section 3.1). 
High indebtedness of PNFCs in the
property-related sector
The composition of corporate
deleveraging varies significantly by type of firm according to whether firms'
business is predominantly property related. As
noted above, corporate sector indebtedness has fallen by 17 percentage points
since its peak in 2009. However, while loans to non-property firms have fallen
by around 30% (GBP 57 billion) since 2008, that for core real estate (CRE)
firms has fallen by around 7% (GBP 29 billion) while that for property-related
sectors has fallen by 15% (GBP 14 billion) (Graph 3.29). The indebtedness of these firms
remains relatively high while commercial property prices remain well below
their previous peak in 2007 – by around 40% in total and almost 50% for secondary
property ([58]).
Inadequate deleveraging by previously highly
indebted PNFCs
Aggregate trends may mask other
differences between PNFCs. The Bank of England ([59]) discusses the extent of deleveraging by the type of firm
distributed by pre-existing levels of indebtedness. It finds that the leverage
of firms that were already highly indebted has continued to rise since 2008, in
marked contrast to the least indebted firms. 
Prudent PNFCs' balance sheets
The risks associated with high PNFCs'
indebtedness may be ameliorated by a consideration of PNFCs' balance sheets and
profitability. Despite the weakness in the level of
gross operating surplus, profitability ratios remain high (Graph 3.30). Measures of relative profitability
held up from 2009 to 2012 – a pattern that has continued in 2013 as growth in
gross operating surplus has outstripped that in gross value added. In addition,
a feature of the PNFC sector that it is a net lender. This trend has continued
in 2012 and 2013.
 PNFCs' holdings of financial assets, including cash, have risen
sharply in the last ten years (Graph 3.31). Moreover, PNFCs' loans to deposit
ratio has fallen sharply recently (Graph 3.32). The rise in PNFCs' financial assets,
including (near-) cash holdings provides a counterweight to high levels of
gross debt and lessens the risks associated with it.
Rising household unsecured lending
Although the rise in unsecured lending
to households is worth noting, it is unlikely to constitute a major risk. Most importantly, unsecured lending accounts for a small proportion
of households' debt (less than 5%) so is unlikely to be of sufficient relative
size to constitute a macroeconomic risk. The vast majority of household debt is
secured. Growth in household disposable income should continue in 2014-15 and
cushion the risks associated with high absolute levels of household debt.
Moreover, 'write off' rates for unsecured lending have decreased sharply since
early 2010 and have now returned to the rates preceding the international
economic crisis. 
3.2.7.   Government
policy – developments and impact 
The Government has instituted policies to
improve PNFCs' access to finance, in particular:
·       the Funding for Lending Scheme (FLS); and
·       the Business Bank.
The Funding for Lending Scheme
The Funding for Lending Scheme (FLS) was
introduced in August 2012 by the Bank of England.
The aim of the FLS is to provide incentives – by providing funding at below
market rates - to banks (and building societies) to expand lending to PNFCs
(and households) by reducing their funding costs which, ultimately, should
translate to lower effective rates of lending and increased availability of
credit. As at Q3 2013, total loans outstanding under the FLS were GBP 23
billion.
The evidence to date on the impact of
the FLS on bank lending to PNFCs has been mixed. On
the one hand, it is difficult to disentangle the impact of the FLS itself and
international factors that reduced wholesale bank funding costs inside and
beyond the UK since the middle of 2012. In addition, the borrowing margin for
PNFCs remains low. Crucially, however, since the advent of the FLS, lending
remains muted and continues to fall.
Conceptually and practically, the FLS is
a well-designed policy; overall, however, it is yet to significantly affect the
supply of credit outstanding to PNFCs. It may be
that further time is required for the FLS to have a significant impact or it
may be that, in the absence of the FLS, credit availability would have been
even lower – that is, other factors are weighing down on lending. The recent
withdrawal of the FLS for loans for housing ([60]) may lessen the likelihood of any 'crowding out' of loans provided
under the FLS for SMEs by loans for households. 
The Business Bank
The aim of the Business Bank, which is
expected to be operational by the second half of 2014, is to deploy capital to
address gaps in the provision of finance for SMEs.
The Bank has been provided with GBP 1.25 billion ([61]) of new capital. In addition, a number
of existing schemes to support access to finance - of a total value of GBP 2.4
billion – of both a debt and equity nature - will be rolled into the Bank. 
The capital provided to the new bank is
relatively small – however, it is expected that the
funds will be leveraged up with the addition of private sector funds.
The government intends that the Bank
will not directly lend or invest in businesses;
rather, it will work in conjunction with the private sector providers to
support and increase the capacity of existing channels of finance. Such
providers may include challenger banks (see above).
The establishment of the Business Bank
is a positive first step forward. Conceptually and
practically, it enables SMEs to obtain funds that they may not be able to do so
via bank credit. However, design and implementation will need to proceed
carefully given the complexities of the issue so that the Bank gains the
confidence of SMEs and potential niche providers of funds to SMEs. It remains
to be seen, however, how quickly the Bank can provide finance to SMEs on a
scale that helps to meet the gap caused by the lack of other funding sources
and that the leverage provided by the private sector will materialise to the
extent envisaged. Moreover, it is important that the Bank operates alongside
the market, and provides funds in a way that is not currently provided by the
market, rather than replace the market ([62]).
Competition in the banking sector
PNFCs' access to finance may be affected
by the degree of competition in the banking sector.
The banking sector is characterised by a small number of large national banks
and relatively few regional banks or regional building societies with a
presence limited to a narrow geographical area. Moreover, the degree of
concentration has increased since the international economic crisis – between
2007 and 2013, for the six largest banks: the share of total assets among all
monetary financial institutions increased from 46% to 55%, for loans to PNFCs
it increased from 64% to 70% ([63]). 
SMEs are heavily dependent on their own
bank to raise funds. For example, over half of SMEs
that sought finance first approached their main bank. Moreover, 71% of SMEs
contacted only one provider in seeking finance ([64]). Anecdotal evidence suggests that some businesses, particularly
SMEs, are deterred from expansion and investment if an application is rejected
by their existing bank as they are unable or unwilling to seek additional
sources of finance, including from other banks.
The dominance of the banking sector, and
the behaviour of SMEs in relation to it, may reflect information issues in the
market. Incumbent banks have an advantage in
relation to retaining SME business particularly if SMEs have been a customer of
the bank for a long period of time – allowing the bank to make a full
assessment of risk and hence the collateral and pricing terms of any loan. More
generally, incumbent banks have an advantage through their provision of current
account facilities which provide them with details on individual borrowers.
An increase in the number of banks would
provide alternative options for SMEs to seek finance in the event that an initial application for finance was rejected
by their existing main bank and wider benefits could be expected to flow from
the increase in competition that such banks could provide. 
A number of small and new so-called
'challenger banks' have commenced operation in the UK in recent years ([65]). It is unclear whether challenger
banks will be able to gain significant market share and, where relevant, expand
activities to the SME sector ([66]). There is
potential for challenger banks to work with the Business Bank, once it is
established, to provide access to finance for SMEs. More broadly, the
government has recognised the issue and is considering action to improve
competition in the banking sector ([67]).
3.2.8.   Conclusion
Private sector indebtedness remains
high; however, the challenge posed by high private sector (excluding household
secured lending) indebtedness is less marked than at the time of the 2013 IDR. In particular, PNFCs remain net lenders with strong balance sheets
that should provide a cushion against vulnerabilities. However, credit supply
remains muted despite recent signs from surveys that demand for, and supply of,
credit may rise. 
The main challenge is constrained access
to funds, impeding PNFCs' ability to expand and
invest. Excessive reliance on the banking sector for funds could constrain
access to finance. A further risk relates to distributional issues, especially
remaining high indebtedness in the property and property-related sectors. 
The government's policy response is
welcome: the Business Bank should, once
operational, help SMEs obtain alternative sources of funds and the recent
refocussing of the FLS towards PNFCs only is appropriate. 
There are particular risks and
challenges associated with high household mortgage indebtedness - flowing from risks and challenges associated with the housing
market - given the high proportion of outstanding mortgage debt in total
household debt. This issue is considered in Section 3.3. 
3.3.      The
Housing Sector and Household Mortgage Indebtedness
3.3.1.   Introduction
The 2013 IDR concluded that high levels
of household debt and developments in the housing sector posed a challenge to
the economy noting that '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'.
The housing sector is unusually
important in the UK economy. Households'
residential building assets account for some 400% of households' disposable
income – a marked increase from the 230% of post-tax income in 1997 (the
previous trough) and approximately equal to the share of financial assets in
disposable income. Household debt has also increased over the medium term, from
90% in 1997 to 140% of disposable income in 2011.
Although residential investment accounts
for only around 3% of total output, the housing sector potentially impacts on
economic growth and stability in a way that is disproportionate to its share in
output. Residential investment decreased by around
40% from its peak in 2007 to its trough in 2009 – greater than the fall in
total output of around 6% from its peak in 2007 to its trough in 2009.
House price movements can outstrip those
in retail prices. For example, house prices
increased by around 150% between January 2000 and their peak in late 2007
compared to an increase of 15% in the Consumer Prices Index (CPI) over the same
period. Since their trough in early 2009, house prices have risen by around 20%
while the CPI has risen by around 16%.
The rate of homeownership is above that
of other large EU Member States – such as France
and Germany – but below that of others – such as Spain and Italy (Graph 3.33).
3.3.2.   Trends
and Developments
Activity
Over the past year, activity in the
housing sector has increased further but remains below the peaks of 2007 and
early 2008. Property transactions have increased
steadily throughout 2012 and 2013 to reach 300,000 in Q3 2013 – more than
double the trough in early 2009 (Graph 3.34). 
The number of mortgage approvals has
also picked up and continues to increase at a steady pace and is at its highest
level since late 2009. Mortgage approvals for house
purchase and re-mortgaging have both picked up although the increase in
activity is greater for mortgages for house purchase (Graph 3.35). 
Moreover, short-term forward indicators
of near-term activity, such as the high sales-stock
ratio and the net balance of new buyer enquiries and newly agreed sales,
suggest that rising levels of activity will continue ([68]) (Graph 3.36). The positive near-term outlook is
supported by indicators for demand for credit for house purchases.
Rising levels of activity reflect rising
demand for housing. A number of factors may have
contributed to buoyant demand.
First, quoted interest rates on fixed
and floating rate mortgages have continued to fall throughout 2012 and 2013
across a range of mortgage products (Graph 3.37). Broadly, the fall in quoted mortgage
rates may reflect a fall in banks' funding costs over this period, for example,
the two year swap rate has also fallen (Graph 3.38).
Moreover, the impact of the Bank of
England's statements regarding the future impact of monetary policy, may have boosted households' confidence to purchase houses in the
expectation that interest rates may remain low for an extended period of time.
Second, households' confidence and
expectations of future income may have risen throughout 2013 in part reflecting
the increase in growth in this period. Survey
measures of households' expectations in relation to their personal financial
position, unemployment and general economic situation all improved in 2013. In
addition, there has been a steady increase in consumers' confidence that now is
a good time in which to make a major purchase (Graph 3.39).
Third, credit conditions facing
households continue to ease as improved conditions in the banking sector mean
that households are subject to weaker credit constraints than in the immediate
past. The availability of, and spreads on, secured
loans to households have improved since their troughs in early 2012, indicating
loosening credit conditions. Since June 2012, mortgage lending rates have
fallen by 0.6-1 pps. depending on the type of mortgage. Credit availability is
expected to improve further in Q1 2014 ([69]). In addition, the number and range of mortgage products available
has increased and the proportion of loans at a loan-to-value ratio of over 95%
is rising. Furthermore, the proportion of new mortgage advances with high
income multiples of all new mortgage advances is increasing and stands at 42%
compared with 38% a year ago and, for first-time buyers, the median mortgage as
a multiple of income has steadily risen from a trough in February 2009 (of 3)
to stand at 3.4 in December 2013 ([70]). However, easing in credit conditions is likely to be reflected in
the stock of credit outstanding to households secured on dwellings with a lag. 
Credit outstanding grew at a 3-month annualised rate of 1.3% in the year to
December 2013, a little more than double that at December 2012 and similar to
the previous peak of March 2012.
Fourth, Government policy is also likely
to have increased demand for housing, namely, through the impact of the Funding
for Lending Scheme (FLS) ([71]) and Help
to Buy policy. The second stage of the scheme, Help
to Buy 2 (loan guarantee), which came into effect in October 2013, enables
households to purchase a property of up to GBP 600,000 in value with a 5%
deposit and with the government guaranteeing 5-15% of the loan. The objective
is to support households to obtain a loan that they may not otherwise be able
to do. Although recently withdrawn for lending to households (see below), the
FLS was in force until the end of 2013 and may have contributed to the falling
in the cost of borrowing noted above.
Fifth, buoyant demand is likely to
reflect a delayed response to high levels of unmet demand during the economic
downturn and international economic crisis – the
result of a structural imbalance between high demand and low supply. 
Supply
The increase in demand is slowly
translating into increased construction of new property. UK-wide data show that starts and completions were broadly
unchanged in 2011 and 2012 but began to pick up in Q2 2013 (Graph 3.40). For England, more recent data
suggests that housing starts picked up in Q3 2013 - starts averaged a little
over 10,800 per month in that quarter compared to around 8,300 per month in
2012 ([72]). 
Moreover, there has been a marked
increase in indicators of future starts and completions - for example, planning approvals granted in Q3 2013 were 33% higher
than a year earlier ([73]).
The increase in supply is already
placing pressure on capacity in the construction sector. For example, there have been reports of shortages of skilled labour
([74]) and
materials ([75]) that may
impede builders' ability to respond to the need to increase supply to meet
increasing demand.
Government policy and supply
A number of policies to stimulate supply
have been announced since the 2013 IDR. The most
significant development is a set of measures to strengthen the National
Planning Framework (NPF) to ensure that economic factors are at the heart of
the planning decisions ([76])([77]).
House prices
Despite some increase in supply, the
increase in demand has resulted in increases in house prices. House prices increased by around 8% in the year to Q4 2013 and the
average pace of growth has picked up from 2012 ([78]). House price levels are close to the level of the previous peak in
2008 (Graph 3.41). Moreover, house prices rises are
occurring from already elevated levels.
A number of indicators indicate that
buoyancy in house prices will continue in the near term. For example, the selling price achieved as a share of asking price
and surveyors' expectations for house price rises are projected to rise (Graphs
3.42a and b).
Affordability
Despite the rise in house prices housing
affordability remains, broadly, at its level of the past four years. Although the cost of borrowing remains low and modest nominal
disposable income growth continues, both factors have been matched by the rise
in house prices leaving affordability broadly unchanged. The pattern is
confirmed by recent movements in the house prices to rent ratio which has also
remained broadly unchanged over the past four years. Nevertheless, both
measures of affordability remain at high levels (Graph 3.43 and 3.44).
Furthermore, a third measure of housing
affordability, mortgage interest payments as a percentage of income, remains
subdued, reflecting the importance of the continued
low cost of borrowing in maintaining improved levels of affordability compared
to the situation before the international economic crisis (Graph 3.45).
Regional house price movements
Momentum in house prices varies across
the regions. As can be seen in Graph 3.46, house price rises have been steepest
in London since 2012, followed by the south east. House price rises outside
London and the south east of England have been considerably more modest.
Moreover, the steep house price rises in
London have occurred from a higher base; the average house price in London is
now considerably higher than that in any other region (Graph 3.47). The high level of house prices in London has contributed to a
reduction in affordability in London relative to other regions of the UK (Graph
3.48).
The difference in house price rises may
reflect the different and prospective economic performance of the regions in
the UK. It may also reflect factors specific to
London, for example, the influence of foreign investors which make cash
payments for property and who are attracted by the 'safe haven' status of the
property market although the evidence to support this view is largely
anecdotal. Moreover, the relative strength of London is unlikely to be a
short-term phenomenon; there is a medium-term trend for large cities to
outperform the rest of the economy ([79]). The study found that in some 'superstar' cities, house prices
continually rise above the national average over a period of around 50 years. 
Given the importance of London in the UK
economy, it is unsurprising, that house price growth in London has outstripped
that in the rest of the UK. Over the medium term,
it is reasonable to expect the trend to continue. If it does, the high and
rising house rises in London pose challenges to the authorities in terms of the
affordability of houses in London, particularly for lower income groups, and
labour mobility between regions of high and low house prices.
3.3.3.   Risks
Four risks are discussed below: 'excessive' rises in activity, house prices and mortgage
indebtedness, an unexpected rise in the cost of borrowing, a negative income
shock, an excessive relaxation of credit standards and an inadequate response
of supply. 
Excessively rapid increases in the level of
activity, mortgage debt and house prices
Most quantity-based measures of housing
sector activity are rising. However, activity is
increasing from a low base and remains well below previous peaks. For example,
the number of transactions, completions and building approvals remain below
their peaks of 2008 as noted above.
Nevertheless, even at modest levels of
activity, house prices are rising (Graph 3.49). As discussed above, near-term
indicators point to such rises continuing and, possibly, intensifying. Past
experience suggests that present house price rises can be followed by further
increases in house prices and be followed by self-fulfilling expectations of
future price rises. Such rises may induce further increases in supply and, of
themselves, deter demand.
The risks associated with rising house
prices are likely to translate into increasing risks relating to household
debt. Rising house prices can be expected to result
in a rise in household indebtedness over the short and medium term as
cumulative rises in new mortgage debt outstrip repayments of mortgage debt
(Graph 3.50). 
Although the stock of outstanding
mortgage debt has increased modestly, it is, nevertheless, rising from high
levels. Given the extent of house price rises, it
could be expected to rise further ([80]). 
Rising mortgage debt may leave
households vulnerable to: a rise in the cost of
borrowing, an unexpected shock to household disposable income and excessive
relaxation of credit standards (in which households acquire excessive debt).
These risks are discussed below. 
However, house prices are rising rapidly
only in London (and, to a lesser extent, the south
east of England). Outside these regions, there has been modest evidence of
house price growth and no evidence of excessive house price growth. Indeed, the
affordability of housing has yet to deteriorate significantly outside London
and has remained broadly unchanged for four years.
Therefore, until rapidly rising house
prices spread beyond London and the south east of England, the risks associated
with house price rises are assessed as moderate in the short term. However, should, in the medium term, rapid house price rises spread
more widely across the UK then the medium-term risks become pronounced.
Rises in the cost of borrowing
The main risk associated with high and
rising household debt is the sensitivity of such debt to rises in interest
rates. As noted above, quoted mortgage rates have
been low and stable for the past four years. This reflects low yields in the
money markets. However, as assessed by market expectations of future rises in
the bank rate, forward market rates are projected to rise in the next 18-24
months (Graph 3.51). Moreover, as 2013 and 2014 have
progressed, the date at which money market rates are projected to rise has
become closer([81]); it is
reasonable to expect that a rise in money market rates translates into a rise
in mortgage rates. 
The extent of the rise in rates faced by
increasingly indebted households depends on whether rates on their mortgages
are fixed or variable. Typically, the majority of
loans taken out are variable rate mortgages. In Q3 2013 around two-thirds of
new mortgage loans were variable rate mortgages ([82]) – a proportion in line with that of the last five years. As a
result, the increase in mortgage rates following a rise in market rates could
be swift. Moreover, households may not have fully taken into account such a
rise in their calculations on their ability to service mortgage debt in terms
of either magnitude or timing - unexpected rises in credit costs can be an
example of 'dangerous near-sightedness' ([83]) which can result in a sharp correction in house prices and
activity with macroeconomic consequences.
Crucially, as noted above, mortgage
interest payments as a percentage of income are at relatively low levels
reflecting a cost of borrowing that is historically low. In addition, household gearing ratios (i.e. interest and mortgage
repayments as a percentage of disposable income also remain at historic low
levels). There would seem to be at least some scope for households, in
aggregate, and in the short term, to absorb a modest rise in mortgage interest
rates should the risk eventuate.
However, in the medium term, the risk is
more pronounced. A sequence of rises in the cost of
borrowing following a rapid rise in house prices and mortgage indebtedness
could leave households vulnerable in the face of higher levels of mortgage
indebtedness. The Governor of the Bank of England (2013) ([84]) has warned households of the risks posed by possible future
increases in the costs of borrowing. 
Furthermore, the aggregate position
masks vulnerabilities across household type. High
levels of debt have amplified the impact of shocks on income but the degree of
amplification is greater for highly indebted households ([85]). An unexpected rise in the cost of borrowing is, therefore, likely
to have a disproportionate impact on highly indebted households. 
Overall, although households are
increasingly vulnerable to rises in the cost of borrowing, the impact of such a
risk on the economy is assessed as moderate in the short term.
A negative shock to household disposable
income
A further risk is an unexpected decline
in household disposable income growth (or future expected income growth). Should the risk eventuate, the ability of households to service the
mortgage stock may be reduced. 
However, this risk needs to be set
against a positive, and improving, economic outlook. Economic growth has surprised on the upside and is expected to
continue at a strong rate in 2014 and 2015 ([86]). Continued growth in nominal disposable incomes is consistent with
nominal economic growth. Moreover, such growth supports households' ability to
service increased mortgages. Even if growth in nominal household disposable
income remains below that of house prices, and mortgage indebtedness, there may
be scope for households to run down savings further to service such debt as the
household saving ratio remains well above its trough of 2008. Over the longer
term, rates of arrears and repossessions have remained low, even during the
crisis and subsequent recession, suggesting that households remain resilient to
shocks (Graph 3.52).
Therefore, the likelihood of the risk
occurring in the short-term, and its impact, is assessed to be modest. However, rising levels of house prices and mortgage indebtedness
leave households exposed to the risk of a negative income shock in the medium
term.
Excessive relaxation of standards and
increases in availability
There is a risk that the relaxation of
credit standards and conditions could intensify and excessive credit made
available to households. Further relaxation of
credit standards could be excessive particularly if it further boosts house
prices or vulnerable households acquire excessive debt and may be unable to
service such debt. 
The signs of the risk materialising are
mixed. On the one hand, some indicators suggest a
relaxation of standards that rivals or exceeds that of the previous sharp and
prolonged rise in house prices. For example, the share of new mortgages for
house purchase with a loan to income ratio greater than 4.5 has increased
steadily since the trough in 2009 and, for properties of a value of GBP 300,000
or more, and for all properties in London, is well above previous peaks of 2007.
Furthermore, more than half of first home buyers have taken out mortgages with
a repayment period exceeding the typical 25 years. On the other hand, however,
the proportion of lenders expecting to increase mortgage applications is not
expected to continue (Graph 3.53). Also, on other measures, there are
signs that standards remain conservative. 
In any case, the authorities have
responded to the risk - primarily by way of the Financial Conduct Authority's Mortgage
Market Review (MMR) ([87]). The MMR is due to come into force in
2014. Banks will be required to verify fully borrowers' incomes and assess that
a mortgage is affordable given net income and essential expenditure, taking
into account market expectations of future interest rate rises. For
interest-only mortgages, lenders will be required to assess affordability on a
capital and interest basis. 
Given the ameliorative measures in
place, the risk of excessively low credit standards is assessed as modest. The measures underway should limit the risks associated with
excessive mortgage lending to households and hence their vulnerability to
unexpected rises in the future cost of borrowing or unexpected falls in future
income. 
Prudent balance sheets 
There is little risk to balance sheets
stemming from increased activity in the housing market. Households' real assets accounts for about half of households'
total wealth. Households' mortgage debt accounts for about 10% of households'
balance sheets. Therefore, households' hold considerable net wealth so their
balance sheets are relatively strong despite high gross household debt levels ([88]). The structure of households' balance sheets increases resilience
to shocks discussed above although this is an aggregate position and masks
differences between households. 
Inadequate response of supply
There is a risk that the supply of new
houses does not respond to the signals sent by rising house prices. As noted above, supply has been slow to respond to recent increases
in demand and, as a result, house prices are rising from an already elevated
base. The extent to which increases in demand translate into higher prices or
increased supply depends upon the price elasticity of the demand curve – the
more price-inelastic the supply curve, the higher the prices that will result
for a given increase in demand. 
The sluggish response of supply to price
signals is a typical feature of housing markets internationally ([89]) but
nevertheless, a divergent response in supply could explain house price
dispersion across countries. For example, one study ([90]) found that, following a house price shock, the price response is
higher in countries with constrained supply. 
The supply responsiveness - which has
been estimated at 0.4 ([91]) - is
likely to be lower than that for demand and is reasonably inelastic. The typical experience of UK housing cycles is that house price
rises, and the rise in the number of transactions, rapidly outstrip increases
in residential construction as discussed above.
The size of the supply response depends
upon the responsiveness of the factors determining the availability of land
that can be developed. Such factors include:
fundamental geographic and demographic constraints, the planning system,
insufficient incentives to for developers to develop land and/or constraints in
obtaining finance. Evidence suggests that the elasticity of supply is
associated with restrictions surrounding land use ([92]) and, moreover, that the elasticity of supply in the UK is around
the average of EU comparative countries for which data is available (Table 3.1).
Planning system
The role of the planning system in
impeding supply has come under particular focus. It
has been argued that the planning system is excessively bureaucratic and
unresponsive to changes in demand ([93]). As a result, the supply of land is restricted and the costs of
developing it are unnecessarily high. The constraints may be particularly tight
around large cities in which land designated as 'green belt' is protected from
development.
Decisions relating to the supply of land
available for housing development are typically taken by local authorities in
the first instance although such decisions are
subject to appeal which is assessed as part of an independent process. As part
of these processes, the planning system attempts to balance legitimate
competing interests on the use of land. Achieving such a balance is not
straightforward in practice. However, in balancing competing interests it is
crucial that the role of economic factors and the government's stated policy of
increasing the supply of houses are given appropriate weight. 
It is unlikely that supply will increase
sufficiently rapidly to meet increases in demand in the short term - although the government has announced, and is implementing, a
number of policies to boost supply, given the constraints and time likely to
elapse before such policies take full effect, constraints on supply are likely
to continue. 
A further risk is that developers obtain
planning permission to develop land but do not proceed with the development. Reasons for such action include: an inability to obtain development
finance, an unexpected shortage of materials or skilled labour or speculation
about future capital gains. Should such action be significant, the supply of
land for development is restricted. It is difficult to assess the extent of
this risk in practice. It is also important to note that at least some land
banks are inevitable as developers seek to manage an appropriate continual
supply of land of development in the pipeline. However, it is noteworthy that
planning permission expires if land is not developed within a particular
timeframe. 
Capacity
constraints
As noted above, there is evidence that
the construction sector may be experiencing capacity constraints. Firms typically report that they are at or near capacity; should
capacity constraints continue, the risk that supply is unable to increase to
meet growing demand is intensified.
Medium-term gap
between supply and demand
More broadly, a shortage of supply is
unlikely to be a short-term phenomenon and could extend to the medium term. Medium-term demand for new houses is likely to be determined by the
rate of new household formation. It is currently projected that, in England, an
average of around 220,000 households will be formed each year between 2012 and
2021 ([94]). However,
new supply is currently around 110,000 per year ([95]) – well below the rate of new household formation. The imbalance
between supply and demand is likely to underpin currently high house price
levels and spur further rises in house prices over the medium term as demand
outstrips supply.
Risks - conclusion
In conclusion, levels of activity remain
below previous peaks. Nevertheless, house prices
are rising and the increase in prices and level of activity is likely to be
reflected in rising levels of mortgage debt (and that rise is occurring from an
already elevated base). The main risk on the demand side is households'
vulnerability to a rise in the cost of borrowing while the response of the
authorities has mitigated risks associated with an excessive lowering of credit
standards. The main risk on the supply side is that reforms to the planning
system and other initiatives to increase supply do not deliver increases in new
housing of the amount required, or do so sufficiently quickly, to forestall
further rises in house prices and mortgage indebtedness. 
Overall, the short-term risks are rising
but remain modest. The rise in activity is based on
stronger fundamentals in the housing market – improved confidence, a low cost
of borrowing and some, and not wholly on an excessive relaxation in credit
availability and standards.
However, in the medium term, as house
prices and household mortgage indebtedness become increasingly elevated, the
risks are more marked, as households are more
exposed should the cost of borrowing rise rapidly and/or a negative income
shock eventuates. There is, therefore, a case for a policy response to mitigate
the impact of potential medium-term risks
3.3.4.   Government
policy - responses and challenges
Demand
Help to Buy 2
As noted above, under Help to Buy 2, the
provision of guarantees by the government improves households' ability to
obtain high value loans with a relatively small deposit. Help to Buy 2 compliments the earlier Help to Buy 1 ([96]) but there are significant differences on the impact on relative
demand and supply. Under Help to Buy 1, there is an increase in the supply of
new property to match each new equity loan whereas the guarantee under Help to
Buy 2 extends to pre-existing property and is unlikely to generate a similar
simultaneous increase in new supply ([97]). 
The impact of Help to Buy 2 on housing
activity and prices depends partly upon its size.
The policy, which is in place for three years, is capped at a total exposure to
the Government of GBP 12 billion, and could be expected to lead to a maximum increase
in loans available of around GBP 100 billion. Even assuming a mid-point
estimate of a contingent liability of GBP 6 billion, the increase in mortgage
lending of around GBP 50 billion over three years is significant although it is
difficult to assess the 'additionality' afforded by Help to Buy 2 – that is,
the number of loans that would have been provided to the same households in the
absence of the policy. However, and as is also the case for Help to Buy 1, Help
to Buy 2 is likely to have boosted general confidence in the housing market and
exerted an impact more widely on prices and activity.
In the absence of a strong supply
response, the predominant impact of Help to Buy 2 is likely to increase house
prices; indeed, supply is likely to respond only
indirectly and slowly given its historically lagged and muted response to
price. House prices are likely to rise further at a time in which house prices
are already rising although the extent of any increase depends on the regions
in which guarantee loans are provided for purchase ([98]). The policy is also likely to increase household indebtedness –
although part of that increase in debt is guaranteed by the government. 
At a time in which credit constraints
are easing in the mortgage market, the need for the policy may diminish. While some constraints remain – for example, as noted above, the
median deposit required for a first home buyer is currently double that of 2008
while that for all home buyers has been volatile but broadly unchanged – the
policy is not explicitly targeted to such segments of the market ([99]).
Close monitoring of credit availability
and associated macroeconomic developments is required ([100]) given the risks associated with Help to Buy 2 and the policy could be scaled back – and/or more closely targeted
– should credit supply growth rise further and credit constraints continue to
ease. 
The Funding for
Lending Scheme 
In November 2012 it was announced that
the FLS would be withdrawn for lending to households – effective from January
2014. Other factors held constant, the FLS could be
expected to affect the cost of borrowing and/or the quantity of finance
available to households and, as such, could have boosted housing sector
activity in 2013.
The withdrawal of the FLS for lending to
households is appropriate. The need for the policy
to continue is unclear given buoyant activity in the housing market and easing
access to credit for households. Continuation of the policy risked further
boosting demand and house prices.
Role of
macro-prudential regulation
There may be scope for a regulatory
response by the Financial Policy Committee of the Bank of England (FPC). Consistent with its responsibilities for protecting and enhancing
the resilience of the UK financial system, in the event that it felt that
excessive credit was flowing to the household sector, and that flow posed risks
to financial stability, the FPC could take action to affect banks' provision of
mortgages. Such actions could include ([101]):
·       decisions on the countercyclical buffer – that is, to require banks
to directly increase loss-absorbing capital against the impact (on banks) of an
economic downturn;
·       make recommendations on maximum loan-to-value ratios, loan-to-income
ratios, debt to income ratios or mortgage terms – to restrict mortgages of a
particular type;
·       make recommendations – or directions – to the Prudential Regulation
Authority (PRA) on bank capital requirements on residential real estate
lending, that is, to require banks to directly increase loss-absorbing capital
against the impact (on banks) of an economic downturn; 
·       make recommendations to the PRA or Financial Conduct Authority (FCA)
on underwriting standards; and/or
·       make recommendations to the Government regarding its Help to Buy
policy.
The FPC only came into existence relatively
recently – an interim FPC held its first meeting in June 2011 - so it is
relatively untested. Many of the options available
to the FPC have been used in other countries. The FPC's views on the trade-offs
between the benefits, costs, risks and unintended side effects associated with
the above suite of options and their relative efficiency and effectiveness in
addressing policy challenges could be further publicly developed. 
There is a case for a more detailed
public assessment by the FPC of the merits of the various instruments available
to it and the situations in which they would be deployed. Such an assessment would increase markets' understanding of the
FPC's reaction function which would boost not only transparency but also the
effectiveness of the instruments if/when they are deployed.
Valuation of the cadastre
Broadly, taxation of owner-occupied
property is levied through an annual council tax – which is collected by local
authorities and is based on property values – and taxes on transfers, viz, stamp duty and inheritance tax. The property value roll – the
basis for the assessment of council tax - has not been updated since 1991. The
UK is one of more than half of Member States that levied property taxes on
outdated cadastral values ([102]).
Use of an outdated property value roll
may lead to distortions: owner-occupied property
becomes under-taxed and there is a bias in the tax system to over-investment in
owner-occupied property, the degree of regression in the tax system increases,
as property values have not increased uniformly across, or within, regions
there can be inter and intra-country distortions and the amount of tax
collected moves inversely with value of the object of the taxation. Moreover,
regular revaluation of the roll would reduce sudden increases in the annual
council tax liabilities. However, other factors held constant, revaluation may
lead to a large, and possibly sudden, increase in taxation, particularly for
groups that have benefitted from rises in house prices since 1991.
An updating of the property value roll
should reduce distortions in the taxation system.
Any excessive tax increases falling on certain groups can be mitigated through
adjustments elsewhere in the taxation system (including property taxation).
Housing supply
Until relatively recently, the planning
system did not place appropriate weight on economic factors such as supporting economic and employment growth. Reforms enacted
by the government in 2012 and 2013 as part of the National Planning
Framework (NPF) ([103]) require
local authorities to place economic factors at the heart of planning decisions
including the demand for housing. A key component is the need to prepare a
Strategic Housing Market Assessment to assess their full housing needs taking
account of household and population projections, migration and demographic
change and caters for housing demand and the scale of housing supply necessary
to meet this demand. In addition, 'local plans' are required that set include
the strategic priorities need to deliver the required number of homes and jobs
in each area.
In December 2013, the government
announced that it would consult on a proposal for a legal requirement for local
authorities to have a local plan in place. Moreover, local authorities are
required by the NPF to take decisions in accordance with their local plan. If a
local authority does not have a local plan in place and, therefore, is unable
to demonstrate that an application for development is inconsistent with its
objectives, then that application is treated as approved. As at December 2013,
76% of local authorities had a plan in place.
The reforms to the planning system are
appropriate. Nevertheless, it will take time for
local authorities to fully reflect such criteria when taking decisions, not
least because they will need to develop the expertise to do so. However, the
increased role played by demand for housing in determining the supply of
developable land for housing should, in time, stimulate supply and represents a
major change from previous practice.
In addition, it is essential that
decisions taken by local authorities are taken efficiently and transparently. Delays are minimised so that new supply can commence as quickly as
possible. Recent policies announced in 2013 aim to increase the efficiency of
the planning system ([104]). 
In order to encourage the release of
more land for development, the government could consider the appropriate
incentive structure for local authorities to increase and speed up the release
of such land in the context of facilitating local
solutions to the issue. Such local solutions may also include the taxation of
vacant property. In addition, the government could consider whether there is a
case for a stronger regional approach to decisions on the supply of land for
development involving clusters of local authorities. 
In conclusion, the government has
undertaken some reform of the planning sector.
Further time is needed to assess whether they will result in a timely increase
in supply and further analysis is needed as to whether barriers to supply lie
outside the planning system. However, there is scope to move further –
including the development of appropriate and targeted incentives for local
authorities to release land with planning permission attached for development in
the context of local solutions to inadequate supply. Local solutions may also
include the taxation of vacant property.
Rental sector
In part reflecting a medium-term decline
in housing affordability, the proportion of households that own a house has
decreased in the UK from 69% in 2001 to 65% in 2013
although the rate of home ownership in the UK is broadly in line with other EU
Member States.
The private rented sector in the UK is
relatively unregulated compared to that in other EU Member States. The rights of tenants and responsibilities of landlords are
relatively limited. 
The rental market may be dominated by a
large number of short-term and relatively insecure temporary contracts. In addition, the 'household overburden rate' ([105]) is higher for renters than for home-owners (Graph 3.54) suggesting that there is considerable
financial pressure on tenants.
There is a case to foster greater
stability in the tenant-landlord relationship in a way that provides greater
security of tenure to tenants. While some tenants
and landlords may prefer short-term tenancy arrangements others may prefer
greater stability in the form of longer-term contracts; in particular, some
tenants may prefer long-term tenancy arrangements that landlords are unwilling
to provide ([106]).
Furthermore, uncertainty regarding tenure in the rental market may encourage
home ownership thus increasing pressure in the housing market.
3.3.5.   Conclusion
Activity in the housing sector can be
expected to increase further. Given the gap between
the formation of new households and supply, demand is likely to continue to
outstrip supply. Relaxation of credit constraints is also likely to boost
demand. Therefore house price rises are likely to continue to rise particularly
in London. It follows that household indebtedness is also likely to rise. 
The challenge associated with high
mortgage indebtedness is, therefore, likely to persist and worsen. There are a number of risks associated with high mortgage
indebtedness: excessive rises in activity and prices, a rise in the cost of
borrowing, a negative shock to household disposable income, excessive
relaxation of credit standards and an inadequate response of supply. Although
the likelihood of the risks materialising in the short term is assessed as
modest, shocks to house prices and household balance sheets may pose more
marked medium-term risks. 
There is scope for action on the demand
and supply sides of the housing market to reduce medium-term risks. Given the regional nature of house prices rises such action may
require local solutions. In the absence of action, the challenge is likely to
worsen further, and persist for longer, and the risks associated with it are
likely to increase.
Following from the analysis in Section 3,
potential imbalances relate to both the external and internal side of the
economy, namely, a medium-term decline in the export share and high private
sector indebtedness, particularly households mortgage indebtedness.
These challenges were also identified under
the Macroeconomic Imbalance Procedure in the 2012 and 2013 IDRs and relevant
policy responses were reflected and integrated in the country-specific
recommendations (CSR) issued to the UK in July 2012 and 2013 (CSR 1, 2, 3, 5
and 6). The assessment of progress in the implementation of the recommendations
will take place in the context of the assessment of the UK National Reform
Programme and the Convergence Programme under the 2014 European Semester. This
section discusses possible ways to address the challenges identified in this
IDR.
The challenge of export performance
Recent growth is based predominantly on
strong private consumption growth. A shift in the composition of growth towards
exports over the medium term would be consistent with a reversal of the trend
deterioration in export market share. To achieve such rebalancing, different
policy approaches could be considered such as:    strengthening the skills
base, improving access to finance, export promotion and increasing investment
in infrastructure.
Closing skill gaps

To stabilise, and possibly reverse, the
decline in export market share, a key challenge is to ensure that the labour force
has the necessary skills and aptitudes. A lack of both intermediate and
advanced technical skills can result in capacity constraints. 
In October 2013, the government announced
plans to improve the quality of apprenticeships in England. Provision of high
quality and targeted apprenticeships can help to boost the availability of
relevant skills. Reviewing the exact nature of apprenticeships in cooperation
with employers could contribute to meet the needs of the business and,
particularly, the exporting sector. 
Correctly accredited vocational training
schemes and concentrating on science, technology, engineering and mathematics
(STEM) in the education system could help meet the requirements of employers.
Addressing the skills gap would also address the 2013 Council recommendation on
young people’s skills
Improving access
to finance
Alleviating apparent credit constraints
could enhance the ability of exporters to receive the finance they need to
expand into export markets. Despite measures implemented by the government to
boost credit supply and facilitate access to alternative sources of finance,
credit supply remains weak, particularly for SMEs. 
The government has a number of initiatives
in place to boost access to finance. For instance, the Funding for Lending
Scheme (FLS) was altered in November 2013 by removing use of the Scheme to lend
to households; the remaining focus on lending to business enables closer
targeting of finance to business. In addition, the government is establishing a
Business Bank to provide alternative channels of finance for SMEs beyond bank
credit. The Bank should be operational by the second half of 2014. SMEs, in
particular, rely heavily on bank finance, thus, improving access to bank
finance, via the FLS, as well as encouraging alternative sources of finance,
via the Business Bank, are welcome and appropriate initiatives to ensure that
SMEs obtain the finance they need to expand and export. 
Furthermore, continuing to foster greater
competition in the banking sector, e.g. by an increased presence of challenger
banks, may help SMEs access credit. Initiatives in this area also respond to
the 2013 CSR on improving credit availability.
Broad-based export
promotion 
There is potential to address information
asymmetries that prevent firms that wish to export from seizing opportunities
to do so. The government has established a number of initiatives to provide
export credit and other supporting services; for instance, services provided by
UK Export Finance and UK Trade & Investment.
The effectiveness of these initiatives
hinges on awareness in the business community, as well as taking appropriate
account of regional diversity in their design. More generally, trade openness
relies on the ability to interact with foreign commercial partners. Finally,
facilitating the recruitment of foreign experts could improve firms' ability to
engage in international trade. 
Investing in
infrastructure
A potential bottleneck hindering
competitiveness results from its under-investment in infrastructure. Improvement
in the quality and quantity of infrastructure could also raise long-term
potential growth by raising productivity. Upgrading and expanding the transport
infrastructure could reduce bottlenecks in distribution. 
The government published an ambitious
National Infrastructure Plan 2013 in December 2013, which sets out investment
plans worth GBP 375 billion to 2020 and beyond. Around two-thirds of the
funds are to be provided by private sources of funds. Most of the investment is
in the energy and transport sectors and is back-loaded time wise. A list of
‘Top 40’ projects has been published; priority projects were chosen based on
their potential contribution to economic growth, national significance and
attractiveness for private investors. Bringing forward the delivery of these
planned projects where possible and ensuring effective implementation would
boost the impact of the Plan. Facilitating increased investment in
infrastructure and harnessing private sources of capital also responds to the
2013 Council recommendation.
The challenge of private sector indebtedness
Although the pace of deleveraging has
slowed, and corporate indebtedness remains high, PNFCs as a whole are net
savers and hold high levels of financial assets. However, aggregate PNFCs' indebtedness
masks the divergence between the construction/property sector and other sectors
for which the size of deleveraging has been greater.
The potential imbalance and risks arising
from private sector indebtedness relate to high household mortgage debt, which
in turn flows from developments in the housing market. 
The housing market
challenge
Demand for housing continues to increase
particularly in London and the south east of England. The increase in demand
may result in an increased imbalance in the housing sector in the short and
medium term as the supply of new houses continues to fall below projected rates
of household formation. House prices are rising steadily, especially in London
and the south east of England and household mortgage indebtedness is likely to
increase. 
Policies to
facilitate households' ability to purchase a house 
The purpose of the government's Help to Buy
scheme is to facilitate households' ability to buy a house.  Whilst the first
phase of the Help to Buy scheme ('equity loan' or 'Help to Buy 1') provides
partial loans to facilitate a mortgage for new houses only, the second phase
('mortgage guarantee' or 'Help to Buy 2'), applies to all houses (existing or
new). The effect on demand of 'Help to Buy 2' is likely to be immediate and
direct while that on supply is likely to be indirect and slow given the
historically lagged and muted response of new supply to demand. Therefore, the
policy is likely to boost house prices further and at a time when they are
already rising. The policy is also likely to increase household indebtedness,
although part of that increase in debt is directly guaranteed by the
government. 
Close monitoring of credit availability and
associated macroeconomic developments is required given the risks associated with
Help to Buy 2 and the policy could be scaled back – and/or more closely
targeted – should credit supply growth rise further and credit constraints
continue to ease.
Macro-prudential
regulation
Consistent with its responsibilities for
protecting and enhancing the resilience of the financial system, in the event
that the Financial Policy Committee of the Bank of England (FPC) felt that
excessive credit was flowing to the household sector, and that flow posed risks
to financial stability, the FPC could take action to affect banks' provision of
mortgages.
There is a case for a more detailed public
assessment by the FPC of the merits of the various instruments available to it
and the situations in which they would be deployed. Such an assessment would
increase markets' understanding of the FPC's reaction function which would
boost not only transparency but also the effectiveness of the instruments if
and when they are deployed.
Reform of property
taxation
By EU standards, the share of property
taxes in total government receipts is high in the UK. However, the efficiency
and effectiveness of the property tax system could be improved.  Taxation of
owner-occupied property is levied through an annual council tax – which is
collected by local authorities and is based on property values – and taxes on
transfers via stamp duty and inheritance tax. The property value roll – the
basis for the assessment of council tax – has not been updated since 1991; a
revaluation would reduce distortions in the taxation system in favour of
owner-occupied housing. 
Reform of the
planning system and supply
Despite improvements in the planning
system, a shortage of supply persists. Better incentives for local authorities
could be considered in order to increase and speed up the release of land with
planning permission for development in the context of facilitating local
solutions to inadequate supply. Improvements in this area would also be a
response to the 2013 Council recommendation on housing.
Promotion of
long-term tenancy agreements
The rental market is relatively unregulated
by EU standards. There is scope to foster long-term tenancy agreements which
could benefit both tenants and landlords. It could also reduce the tendency
towards high home-ownership rates, which in turn might relieve pressure on
rising house prices, driven by those attempting to get onto the property
ladder.
Curtailing the
risk of excessive relaxation of credit standards
The bank rate is currently at an historic
low and many households are currently able to borrow at historically favourable
mortgage rates. Given that much recent new borrowing is at a variable interest
rate, there are potential risks to households' ability to service mortgages
should the cost of borrowing increase. The reform of the mortgage market in the
Financial Conduct Authority’s Mortgage Market Review is due to come into
force in April 2014 and is designed to limit particularly high-risk lending and
support the maintenance of high credit standards and prudent lending.
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Bank of England, 'Financial Stability
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Bank of England, Inflation Report May
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Breedon, T., Report of the industry-led
working group on alternative debt markets (the 'Breedon Report'), 'Boosting
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British Bankers Association, 'High street
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Business Bank Advisory Group to the
Department of Business Innovation and Skills, 'Letter to the Secretary of State
Ref: Business Bank Advisory Group Recommendations', 24 June 2013
Capital Economics, 'The UK Housing Market
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Chartered Institute of Building, 'Skills in
the UK Construction Industry', 2013
Confederation of British Industry, 'Connect
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Construction Products Association,
'Qualitative Analysis of UK Construction Manufacturing Capacity', September
2013
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Pontuch, P. and Raciborski, R. 'Indebtedness, Deleveraging Dynamics and
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Department for Business, Innovation &
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Department for Business, Innovation &
Skills, 'Building the Business Bank, Strategy Update', 2013
Department of Communities and Local
Government, 'Help to Buy (equity loan) scheme, monthly statistics', 2013a
Department of Communities and Local Government,
'Help to Buy: Equity Loan scheme and New Buy statistics, Data to September
2013', 2013b
Department of Communities and Local
Government, 'House Building September', 2013c
Department of Communities and Local
Government, 'Household projections, United Kingdom', 2013d
Department of Communities and Local
Government, 'Housing Statistics Table 209 April', 2013e
Department of Communities and Local
Government, 'National Planning Policy Framework', 2012
Department of Communities and Local
Government, 'National Planning Framework', 2012
Dustmann, C. and Frattini, T., 'The Fiscal
Effects of Immigration to the UK', CReAM Discussion Paper Series 1322, Centre
for Research and Analysis of Migration (CReAM), Department of Economics,
University College London, 2013
Ernst & Young, 'Ernst & Young’s
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European Commission, '2013 SMEs’ Access to
Finance survey', 2013a
European Commission, 'Education and
Training Monitor 2013, United Kingdom, 2013b 
European Commission, 'European
Competitiveness Report 2013', 2013c
European Commission, 'European Economic
Forecast, Autumn', 2013d
European Commission, 'Internationalisation
of European SMEs', 2010
European Commission, 'Labour Market
Developments in Europe 2013', 2013e
European Commission, 'Product Market Review
2013 – Financing the real economy', 2013f
European Commission, 'Quarterly Report on
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European Commission, 'Tax Reforms in EU
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([1])  However, it should be noted that part of the decline is due to
the reclassification of further education and sixth form colleges in England from
the public to the private sector in 2012; this accounts for 3.2 pp. of the
decline.
([2])  ONS Labour market statistics, December 2013.
([3])  Eurostat data.
([4])  Idem.
([5])  Macroeconomic Imbalance Procedure
Scoreboard
([6])  Commission services Winter 2014 Forecast.
([7])  As a result of quantitative easing, the
coupon payments linked to assets held by the Bank of England Asset Purchase
Facility Fund Limited (BEAPFF), a subsidiary of the Bank of England, are being
transferred to the general government accounts.
([8])  Bank of England (2014).
([9])  European Commission (2013d).
([10]) A destination country is 'dynamic' if
its total imports grow faster than world total imports.
([11]) In terms of relative growth rates of
imports.
([12]) The size of the bubble indicates the
weight of a destination on total exports of the UK.
([13]) For example, Bahmani et al (2013) show
that a devaluation may be less effective than might be supposed in its effect
on a country's competitive position. Although for some sectors there may be an
improvement in net exports, for many others there is not, and it is not clear a
priori which sectors will react positively.
([14]) Chapter II.2 in the Product Market
Review 2013 European Commission (2013g) explores the capital allocation
process between tradable and non-tradable sectors in terms of incentives and
constraints using firm-level data.
([15]) Firm-level data also shows that
investment rates in tradables are, at best, reaching their pre-crisis levels.
([16]) UK government (2013a).
([17]) European Commission (2013c).
([18]) Albarran et al. (2013).
([19]) Ernst & Young (2013).
([20]) Besides infrastructure, the UK holds
Foreign Direct Investment's leadership in Europe – measured by number of new
projects - and further market research finds that foreign investors’
perceptions of the UK’s labour skills, employment costs, transport
infrastructure and corporate taxation are of world-class and have all improved
recently.
([21]) HM Treasury (2013b).
([22]) UK government (2013b).
([23]) National Audit Office (2013).
([24]) Pensions Institute (2013).
([25]) National Association of Pension Funds
(2013).
([26]) Confederation of British Industry
(2013).
([27]) OECD (2013a), OECD (2013b), McKinsey
(2013).
([28]) Schools can fulfil the requirement by
offering either ancient or modern languages.
([29]) McKinsey (2013).
([30]) European Commission (2013b).
([31]) The survey covered England and Northern
Ireland.
([32]) Office for National Statistics, 2013.
([33]) The analysis is based on European
Commission (2013e).
([34]) The Beveridge curves corresponding to
short and long term unemployment exhibit the same movement along the Y-axis, as
the vacancies are not specific to the duration of unemployment.
([35]) HM Government (2013).
([36]) Richard (2012).
([37]) Social Mobility and Child Poverty
Commission (2013).
([38]) See UK Commission for Employment and
Skills (2013).
([39]) OECD (2013b) shows that England is the
only country where adults aged 55-65 perform better than 16-24 year olds in
both literacy and numeracy.
([40]) In addition, migration could be good
for the economy as a whole. Dustmann and Frattini (2013) show that immigrants
to the UK have made a positive fiscal contribution between 1995 and 2012.
([41]) See European Commission (2010). 
([42]) BDRC (2013). 
([43]) European Commission (2013a) finds that
access to finance is reported as the third most pressing problem for UK
businesses (15.4%, equal to the EU average).
([44]) See European Commission (2013f) for
evidence on how difficulties accessing finance decreased the probability of
manufacturing firms becoming exporters in 2008 by negatively affecting their productivity.
([45]) BDRC Continental (2013). Survey results
refer to loan applications made between the second quarter of 2012 and the
third quarter of 2013. 
([46]) Federation of Small Businesses (2013). 
([47]) See Monteiro (2013) for a review of
survey evidence.
([48]) Business Bank Advisory Group to the
Department of Business Innovation and Skills (2013) 
([49]) All data is quoted on a consolidated
basis unless otherwise indicated.
([50]) See European Commission (2013h).
([51]) See Cuerpo et al (2013).
([52]) GfK UK Consumer Confidence Measures
December 2013. 
([53]) Bank of England (2014), Credit
Conditions Survey, 2013 Q4.
([54]) See European Commission (2013a) 
([55]) There is also a link between adequate
access to funds and productivity.  Evidence suggests that, in the euro area, decreases
in firm level productivity can be linked to credit supply conditions  See
European Commission 2013(d).
([56]) See Cuerpo, C. et al (2013) which
states 'credit conditions are an important qualifying factor for deleveraging
processes and their assessment provides useful information to better understand
deleveraging pressures…..in short, credit supply constraints….have a direct
impact on non-financial sector deleveraging'.
([57]) Breedon (2012). 
([58]) See Bank of England (2013a). 
([59]) See Bank of England (2013a).
([60]) See Bank of England (2013d). The
changes took effect on 1 January 2014.
([61]) Department for Business Innovation and
Skills (2013) The capital will be used to: invest in late stage venture capital
funds which in turn invest in high growth potential SMEs, launch a scheme to
support the provision of lease and asset finance, and provide wholesale
guarantees for loans to SMEs.
([62]) The activities of the Business Bank
will need to be compliant with the EU's State Aid Regime.
([63]) Bank of England, unpublished data.
([64]) See Breedon Report (2012).
([65]) Year established as a stand-alone bank
in the UK in parentheses: Metro Bank (2010), Aldermore (2009), Handelsbanken
(2012) and Virgin Money (2012) although Metro Bank and Virgin Money have, to
date, offered predominantly retail banking services. Virgin Money is not
technically a new entrant to the market as it has increased market share by
taking responsibility for much of Northern Rock's previous business.
([66]) As argued by the UK Independent
Commission on Banking (2011), for a new bank to inject competitive
pressure into the market, it should have sufficient scale and financial
backbone to act as a challenger bank. In the past, only banks with a
sufficiently high share have been able to grow and act as challengers to the
incumbents. The Commision on Banking also recommended the creation of a new
challenger bank through the divestiture of assets belonging to Lloyds Bank. 
The creation of an independent new bank, TSB, is underway.
([67]) For example, the government is consulting
on proposals to require banks to share information on their SME customers with
other lenders through credit reference agencies. The Office for Fair Trading is
collecting evidence on the anti-competitive practice of banks potentially
requiring SMEs to open or maintain a business current account in order to
qualify for a loan.
([68]) Royal Institute of Chartered Surveyors
(RICS) Residential Market Survey December 2013.
([69]) See Bank of England (2014).
([70]) A high income multiple is defined as 4
or higher on a single income or 3 or higher on a joint income. Source: Bank of
England (2013b), Capital Economics (2014a and b)
([71]) A brief explanation of the FLS can be
found in Section 3.2.8.
([72]) The data in this sentence is for
England only as data for the UK after Q2 2013 had not been published at the
time of publication of the IDR.
([73]) See Home Builders Federation (2013).
([74]) See, for example, UK Commission for
Employment and Skills (2014). 
([75]) See, for example, Construction Products
Association (2013).
([76]) See HM Treasury (2013). 
([77]) In December 2013, the government
announced that it would consult on a proposal for a legal requirement for local
authorities to have a local plan in place.  Local plans need to set out
expected demand for housing and the impact of economic factors such as
employment and growth. Moreover, local authorities would be required by the NPF
to take decisions in accordance with their local plan. If a local authority did
not have a local plan in place and, therefore, is unable to demonstrate that an
application for development is inconsistent with its objectives, then that
application is treated as approved.
([78]) According to the most recent monthly
data, in the twelve months to January 2014, house prices increased by 8.8% and
7.3% according to the Nationwide and Halifax price indices respectively.
([79]) As argued by Gyoruko, Mayer and Sinai
(2006). 
([80]) Rises in household indebtedness are
projected by the Office for Budget Responsibility (2013).
([81]) Dates are indicated according to the
date of various Inflation Reports published by the Bank of England.
([82]) Bank of England (2013e). 
([83]) Glaeser et al (2008). 
([84]) Governor of the Bank of England (2013).

([85]) Bank of England (2013c). 
([86]) As set out by European Commission (2014).
([87]) In addition, other actions taken by the
authorities mitigate the risk: the FLS can no longer be used to provide credit
for housing (see section 3.3.4), the Prudential Regulation Authority (PRA) has
ended its temporary capital relief on new household lending qualifying for the
FLS and the Financial Conduct Authority requires mortgage lenders to have
regard to any future FPC recommendations on appropriate interest rates stress
tests to use in the assessment of loan affordability.
([88]) However, although the aggregate solvency
risk seems small, there is liquidity risk, for example, a proportion of
households' financial assets are likely to be held as insurance reserves which
are less liquid than other forms of financial assets.
([89]) see e.g. OECD (2008). 
([90]) Gattini and Ganoulis (2012). 
([91]) OECD ibid. 
([92]) See OECD ibid.
([93]) UK Government (2012). 
([94]) Department of Communities and Local
Government (2013d). 
([95]) Department of Communities and Local
Government (2013c). 
([96]) Under the Help to Buy 1 (equity loan)
scheme that came into effect in April 2013 the UK Government provides an equity
loan of between 5 and 20 per cent for households seeking a loan for the
purchase of a new property of up to GBP 600,000 in value with a minimum deposit
of 5%. The aim of the policy is to enable households to purchase new build
property but would otherwise lack the funds sufficient to obtain a deposit to
do so. 
([97]) As at December 2013, around 13,000
equity loans had been completed under Help to Buy 1 of which a little under
1000 were in London boroughs. See Department of Communities and Local
Government (2013a)
([98]) Under Help to Buy 1, as set out in
footnote 79, the majority of equity loans were provided for purchase outside
London. Should a similar pattern of guarantee loans be provided under Help to
Buy 2, then the impact on house prices is likely to be less than if most loans
were provided for purchase in London.
([99]) Although it is worth noting that, as at
September 2013, 92% of loans advanced under Help to Buy 1 were to first home
buyers. See DCLG (2013b). Data is not yet available for guarantee loans under
Help to Buy 2 although, under both arms of the policy, loans are available at
only high loan-to-value ratios, suggesting that first home buyers are likely to
benefit disproportionately.
([100])         The Financial Policy Committee
of the Bank of England is required to report to the Government if it believes
that the policy poses risks to financial stability.
([101])         As set out by the Bank of
England) (2013b). Some of these actions are implemented by powers to give
recommendations or directions to the PRA and the FCA.
([102])         European Commission (2013i). 
([103])         Department of Communities and
Local Government (2012). 
([104])         For example, it has been
announced (UK Government 2013a) that the government would: review the Nationally
Significant Infrastructure Planning Regime, consult on introducing a
requirement to have a local plan in place, address delays associated with the
discharge of planning conditions and reduce the number of applications for
which statutory consultation is required.
([105])         The overburden rate is the %
of the population living in households for which the total housing costs (net
of housing allowances) represent more than 40% of disposable income (net of
housing allowances).
([106])         For example, according to a
recent survey among renters in London, 66% of respondents wanted reform for
'the option of a longer-term tenancy so I can settle in my home'. See Shelter
(2013).