Date: 2007-03-26 | Ministry of Finance
The Norwegian economy is entering its fourth consecutive year of above-trend growth, while wage and price inflation have been remarkably subdued. This enviable performance has been underpinned by the two strong macroeconomic policy pillars of inflation targeting and the fiscal guidelines, both adopted in 2001.
INTERNATIONAL MONETARY FUND
2007 Article IV Consultation for Norway
Preliminary conclusions of the mission
The Norwegian economy is entering its fourth consecutive year of above-trend growth, while wage and price inflation have been remarkably subdued. This enviable performance has been underpinned by the two strong macroeconomic policy pillars of inflation targeting and the fiscal guidelines, both adopted in 2001. A combination of several factors have boosted demand and eased supply constraints: supportive monetary conditions following the 2002-03 slowdown; an expansionary fiscal stance; high world prices for petroleum products and other Norwegian exports and much weaker prices for imported goods; labor inflows, especially from the new EU member countries; and increased competition and productivity in some domestic sectors.
However, indicators point to mounting underlying inflationary pressures. Credit growth and house-price increases have been strong for some time, and the former has moved beyond households with a sharp pick-up in business-sector borrowing. Capacity utilization is high. And, after a muted response early in the cycle, labor markets tightened significantly in the past year, with near record employment growth, a plunging unemployment rate, and increasing reports of labor shortages and, in some industries, rising wage drift.
Such pressures appear set to intensify, as the mainland economy is expected to grow strongly again in 2007. The pace will probably slow somewhat, however, as a less accommodative monetary stance restrains demand and capacity constraints begin to bite, notwithstanding further labor inflows from central Europe. Export and petroleum prices are likely to receive continued support from global demand, despite a slowing in the United States, as European economies gather pace and growth in emerging-market Asia remains robust. Thus, while the social partners are aware of the need for wage moderation, pressures could increase in the run-up to the two-year wage negotiations in spring-2008.
Against this backdrop, Norges Bank’s (NB) decision to withdraw monetary stimulus, beginning in mid-2005, as well as the recent pick-up in the pace of interest rate increases, is welcome. However, monetary conditions are still accommodative. Given prospective inflationary pressures, NB should therefore continue its policy of interest rate increases, although the exact pace will depend on economic developments. Monetary tightening will be accompanied by some temporary upward pressure on the exchange rate, but current high profitability suggests the exposed sector will be able to weather this. In any case, undue delay in withdrawing stimulus would at, a later stage, necessitate sharper increases in interest rates and correspondingly greater exchange rate pressures.
The inflation targeting framework, together with a flexible exchange rate, has proven effective and appropriate for the Norwegian economy. A number of innovations have strengthened policymaking and communication, putting Norway at the forefront of inflation targeters. These include independent annual evaluations, periodic testimony by the governor to parliament, detailed discussion of policy decisions, and the publication of fan charts and NB’s own interest rate forecast. Nevertheless, to reinforce public understanding of inflation targeting, the authorities should continue to clearly explain the framework and how it governs specific policy decisions.
The financial sector appears to be sound and well supervised. Loan losses are very low, and steadily declining interest margins reflect improved efficiency and strengthened competition. The bulk of the recommendations from the FSAP have been implemented. However, the prolonged strong credit expansion, the steep rise in house prices, and increasingly aggressive mortgage lending (very high loan-to-value ratios and more floating-rate and interest-only mortgages) pose risks, especially as interest rates rise and in the event of an economic slowdown. The Financial Supervisory Authority is closely monitoring these developments, and should continue to ensure that banks remain well capitalized and provisioned, and that their lending practices remain sound and their asset quality high.
Fiscal policy has been prudent, and it is particularly welcome that in 2007, for the first time, the central government non-oil structural deficit is set to meet the target of 4 percent of the assets of the Government Pension Fund Global (GPF), in line with the fiscal guidelines. As the guidelines explicitly recognize, fiscal policy has a role to play in economic stabilization, and it was used to support activity in the 2002-03 downturn. Likewise, in response to the current upswing, the 2007 mid-term budget review should seize any available opportunity to reduce the deficit, while the 2008 and subsequent budgets should aim for a deficit materially below 4 percent of the GPF until excess demand dissipates. Such policies would alleviate the burden on monetary policy and ease upward pressure on the real exchange rate.
The fiscal guidelines, and the 4-percent rule in particular, have helped to restrain spending, allowing the Norwegian economy to benefit from petroleum wealth while blunting “Dutch disease” effects. Nevertheless, petroleum prices are much higher now than when the guidelines were put in place and, as a result, the expansionary fiscal impulses arising from following the 4-percent rule have become stronger than then anticipated. Apart from temporary departures from the rule for countercyclical purposes just discussed, the result will be lower taxes or a significant run-up in spending. Tax cuts would be welcome because of their desirable supply-side effects. Spending increases, which would be consistent with the government’s commitment to maintain the revenue-GDP ratio at its 2004 level, risk inefficient resource use. In this regard, an explicit medium-term fiscal framework, which in one form or another is increasingly common among advanced economies, would help to manage the fiscal expansion. In Norway, many parts of such a framework are already in place, notably the fiscal guidelines themselves and the finance ministry’s multi-year budget projections. Fiscal planning also should take into account the consequence of the 4-percent rule that, on current assumptions about petroleum prices, spending increases will have to be reversed beginning in the early 2020s.
The most important long-term fiscal challenge is posed by the effects of population aging, expected to begin in the next decade. The recent broad-based parliamentary agreement on pension reform, which closely follows the government’s 2006 white paper, is therefore welcome. The reforms, once implemented, promise improved work incentives and long-term pension savings.
The authorities’ intention to deal with a number of outstanding issues is also welcome: (i) reform of the AFP (early retirement) program to reinforce the actuarial features of the pension agreement would help to preserve work incentives; (ii) reform of the large public employee pension program would be crucial to long-term fiscal sustainability; and (iii) aligning disability benefits with pensions would, in particular, help to contain the former. However, the saving from the agreed reform will probably be insufficient to ensure long-term fiscal sustainability, especially in view of prospective declines in petroleum revenue, and therefore further reform should be considered.
The Norwegian labor market performs well, with high employment and participation rates, and low unemployment rates. The ability to absorb substantial numbers of immigrant workers testifies to its flexibility. However, assessment of labor market conditions would be improved by monthly labor-force survey estimates and an establishment survey for timely data on employment and wages.
Owing to rising enrollment, sickness and disability schemes now account for a substantial fraction of the working-age population and impose a significant fiscal burden. The merger of welfare agencies is welcome, as it may streamline and improve the disposition of cases, but further administrative reforms will be required. These include reducing the gatekeeping and assessment function of general practitioners in favor of specialized social insurance physicians; greater use of partial disability; and better use of measures to return the sick and disabled to productive work. In addition, generous benefits (high replacement rates) in the sickness and, for many, in the disability program should be reconsidered in order to sharpen beneficiaries’ incentives to return to work.
Product market performance also appears to be improving, especially in the financial and services sectors, with greater competition being one factor that has held prices down and raised productivity in recent years. Efforts should be continued in this area, with strong enforcement of competition and anti-cartel laws. A notable feature of the Norwegian economy is the large public-sector involvement, which the government has strongly supported, in part to ensure that head-office activities and competencies remain in Norway. Public ownership might be perceived as creating a non-level playing field, since state-owned or controlled enterprises (SOEs) could have access to deep public pockets in the event of difficulty and are shielded from some market discipline, notably takeovers. The current system of SOE governance, which appropriately emphasizes commercial goals, arms-length management, and transparency, mitigates such concerns, and therefore needs to be maintained; privatization, however, should be considered in some cases.
Oslo, March 26, 2007