Date: 2007-02-09 | Ministry of Finance
INTERNATIONAL MONETARY FUND
Norway – 2006 Interim Staff Visit
Conclusions of the Mission
Norway is enjoying a period of enviable prosperity, underpinned by a strong macroeconomic policy framework at home and favorable developments abroad. The economy continues to grow rapidly and the near-term outlook is bright. Low interest rates have fueled high growth in private consumption and investment, while robust foreign demand has supported exports. Wealth effects, notably high house prices, have amplified the expansion of domestic demand. Finally, high oil prices have stimulated a sharp acceleration in investment in that sector, boosting demand for related goods and services in the mainland economy. The robust expansion of activity is set to continue in the near term, although changes in world growth or oil prices would significantly affect the outlook. At some point, high and rising household indebtedness could weaken consumption, and in the longer term high production costs and eroding competitiveness could dampen growth.
Core inflation has remained well below the inflation target for some time, although headline inflation has edged up. Key factors contributing to lower inflation have been falling prices for some imported consumer goods, reflecting a shift in sourcing to low-cost countries, and increased domestic competition in some sectors. In addition, the output gap had until recently been negative, while rising labor inflows and the slow response of employment to strong economic conditions have moderated wage growth.
Against this backdrop, Norges Bank’s (NB) policy of gradually increasing its intervention rate in “small and not too frequent steps” is appropriate, and the cumulative one percentage point increase put in place during the past year is welcome. Nevertheless, monetary conditions remain expansionary, and the combination of low core inflation and strong economic growth continues to pose a dilemma for policy. NB needs to avoid tightening too rapidly, which would unduly restrain growth. But not tightening fast enough could risk inflation overshooting the target, necessitating a sharp increase in interest rates, with adverse exchange rate effects. Recent developments – notably a steep increase in employment, falling unemployment, rising credit growth to enterprises, and a re-acceleration of house prices – suggest that inflationary pressures may be intensifying. If so, given lags in the effect of monetary policy on inflation, the pace at which monetary stimulus is withdrawn may have to pick up.
The inflation targeting framework is effective and has benefited from several commendable innovations. These include independent annual policy evaluations, periodic testimony by the governor before parliament, the publication of monetary policy assessments at the beginning of each four-month strategy period, and more detailed discussion of policy decisions. More recently, NB introduced further welcome increases in transparency by publishing its own interest-rate forecast and introducing fan charts to highlight forecast uncertainties. Public understanding of inflation targeting has improved, but the authorities need to continue their efforts to communicate the framework, emphasizing in particular that the exchange rate, while taken into account, is not an independent policy target.
Norway’s fiscal policy has been prudent, and we welcome the new government’s support for the 2001 fiscal guidelines and its decision to implement the last steps of the labor and business income tax reform package. The guidelines allow sustainable use of oil revenues while preserving realized oil wealth for future generations and, in particular, for covering pension outlays. Constraining fiscal deficits and investing the bulk of petroleum revenues abroad curb upward pressure on the real exchange rate, mitigating so-called Dutch disease effects. A weakness in the application of the guidelines has been that deficits have always exceeded the benchmark of 4 percent of the assets of the Government Pension Fund-Global (GPF). While the deviations have been relatively small, their continuation in a period of very strong growth and high oil prices could call into question the credibility of the guidelines themselves. We therefore urge that the deficit be held to 4 percent of the GPF in the 2007 budget.
After 2007, if oil prices remain high, the 4-percent fiscal rule will imply sizeable increases in structural deficits, which will impart significant fiscal stimulus in an already strong business cycle upswing. It would be prudent, therefore, to hold the deficit below 4 percent of the GPF until cyclical pressures ease, as envisaged in the fiscal guidelines. Such a posture would help to contain inflationary pressures, reduce the burden on monetary policy, and ease upward pressure on the exchange rate.
The additional resources from higher oil revenues will also, under the fiscal guidelines, require significant tax cuts or spending increases. There is scope to cut taxes, especially on labor, to stimulate employment and strengthen competitiveness. In the same vein, spending measures that would discourage labor supply should be avoided. In any event, the extra spending may be difficult to absorb, which could result in inefficiencies rather than expanded or improved public services. Such risks would be mitigated by forward-looking planning, which would benefit from being embedded in a more comprehensive multi-year fiscal framework. Implementation of such a framework should be technically straightforward. The fiscal guidelines would form its backbone, and the ministry of finance already produces detailed, though nonbinding, multiyear fiscal projections.
The key long-term fiscal issue in Norway is the rise in aging-related spending as the pension system matures and demographics worsen. The package of pension reforms agreed a year ago promises significant long-term budgetary savings, and its prompt implementation would therefore be welcome. A key aspect of this package is the flexible retirement provision, which is intended to provide for early retirement while maintaining work incentives, thereby sustaining the tax base and easing the fiscal strain due to the pension system. To ensure that such benefits materialize, complementary reforms are needed to align disability and early retirement replacement rates and to narrow public subsidies to the early retirement program (AFP).
The financial system appears to be in good health, buoyed by favorable macroeconomic conditions, and last year’s FSAP found it sound, well managed and supervised, and resilient to shocks. Declines in loan losses and earlier cost-cutting have improved the performance of the banking sector, which is well capitalized and profitable. Life insurance companies have increased their buffer capital, although they still face challenges from the combination of low interest rates and reliance on guaranteed-return products. Pension funds have benefited from rising global equity prices in recent years.
However, Norway is experiencing rapid credit expansion and an asset boom, which could become increasing sources of risk in the years ahead. Total credit to mainland Norway, as a percentage of GDP, is at a historically high level and rising, with mortgage lending being an important component of the increase. Since most mortgages carry floating interest rates, the debt burden on households, although still relatively low, is expected to increase as interest rates return to neutral levels. Credit to nonfinancial enterprises, which had been sluggish until 2005, is growing rapidly. House prices are high by historical standards and continue to rise, posing risks of a future reversal. Equity prices on the Oslo Stock Exchange have more than tripled since the beginning of 2003, although there has recently been a downward correction. The Financial Supervisory Authority is closely monitoring credit developments and has urged more restrictive lending for housing purposes. This vigilance is welcome, but more measures may be needed if the pace of credit growth does not abate.
The Norwegian labor market performs very well in most respects, but extensive and increasing recourse to the sickness and disability programs is taking its toll. The participation rate, among the highest in the world, has declined since 2001, in part reflecting increases in disability and early retirement. Following welcome administrative reforms, hours lost to sickness fell, but have recently begun to rise again. These developments point to the need to consider further strengthening administrative controls and to reconsider the very high replacement rates, especially in the sickness program.
Oslo, June 12, 2006