Public Information Notice No. 08/64

Public Information Notice: IMF Executive Board Concludes 2008 Article IV Consultation with the Kingdom of the Netherlands

June 3, 2008

On May 21, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Kingdom of the Netherlands—Netherlands.¹

Background

Strong macroeconomic foundations have so far largely shielded the Netherlands from recent financial turbulence. Growth in recent years has been above and inflation below euro area averages. Economic expansion is expected to slow this year to 2-2¼ percent, which, in light of a large carryover from 2007, reflects a substantive deceleration owing to the global turmoil and spillover from the U.S. downturn. Inflation should remain subdued, slightly above 2 percent, although with a tightening labor market, wage increases are anticipated to accelerate somewhat and to exceed productivity growth. Uncertainties surrounding the outlook are high, mainly owing to uncertainties on the extent of the global financial distress and its impact on consumer and producer confidence, but the risks are broadly balanced.

The external current account surplus remains large and various approaches support the conclusion that Dutch competitiveness is satisfactory. Thus, standard real effective exchange rates have been relatively stable in recent years, while application of the Consultative Group on Exchange Rates (CGER) methodology suggests that the real exchange rate is broadly in equilibrium. Rapid export growth also implies that external competitiveness is not at stake, although sectoral analyses capture some early signs of erosion.

Fiscal performance, while staying strong, was mildly procyclical in 2007. Although the overall surplus was unchanged at ½ percent of GDP, with output above potential, the structural balance slipped by about ½ percent of GDP. Despite a declining government debt ratio and a strong, fully-funded pillar of the pension system, population aging is anticipated to increase government expenditure by some 7 percentage points of GDP in the coming decades and, without fiscal retrenchment or growth-enhancing structural reforms, render the public accounts unsustainable.

The financial system is proving generally resilient to the recent market turmoil, but some pockets of weakness warrant caution. Stress tests suggest that banks can withstand quite strong shocks, in particular those associated with the ongoing financial turbulence. Risk-weighted capital ratios are comfortable, although the return on assets remains low. While mortgage lending has slowed, the outstanding stock remains among the highest in relation to GDP in mature markets, owing to policy-induced distortions—especially the tax deductibility of mortgage interest payments—and exposes households to interest rate and housing price risks. The takeover of a large bank by an international consortium typifies rising challenges for cross-country supervision.

Executive Board Assessment

Executive Directors noted that sizeable fiscal consolidation and stability-oriented macroeconomic policies, complemented by broad-based structural reforms, have underpinned an extended period of strong growth, outperforming the EU average, and have shielded the economy from the recent global financial turmoil. Directors considered that, despite an expected deceleration in growth following the U.S. economic slowdown, near-term prospects remain favorable, with real GDP expected to continue expanding above the EU average. They acknowledged, however, that the outlook is subject to greater-than-usual uncertainty.

Directors noted that imminent population aging—which will shrink working age population starting early in the next decade—and comparatively low productivity growth could pose considerable challenges to long-term fiscal sustainability and external competitiveness. It will therefore be important to make early progress on labor and product market reforms aimed at raising the employment rate and stimulating faster productivity gains.

Given the expected above-potential output and tight labor market, most Directors agreed that a somewhat tighter fiscal stance for 2008 and 2009 would be appropriate from both long-term sustainability and cyclical perspectives, while acknowledging that the scope for reducing current expenditures might be limited at the present juncture of an economic downturn. Should growth turn out to be markedly lower than projected, automatic stabilizers should be allowed to operate fully. Directors welcomed the commitment of the government to a medium-term structural surplus target of 1 percent of GDP, although most saw scope for a further gradual improvement in the structural primary balance (net of gas proceeds), noting that frontloading the fiscal adjustment would limit the size of the needed fiscal correction and distribute the burden more equitably across generations.

Directors concurred that fiscal adjustment should rely on spending restraint and a broadening of the tax base, given relatively large tax wedges on labor income. Possible sources of savings include efforts to control health care spending, improvements in public sector efficiency, an increase in the effective retirement age, and a reduction in unemployment benefits. Directors also called for increased transparency of tax expenditures to strengthen budgetary discipline.

Directors welcomed the ongoing efforts and the recent announcement of new measures to ease growing labor shortages and the impact of population aging. In this regard, reforms of the tax system and social entitlements should aim to reduce the effective marginal tax rates on second family earners, target tax incentives to induce participation by the elderly, and tighten the enforcement of work availability requirements and reassessments of disability status. Directors encouraged the authorities to further liberalize the rigid employment protection legislation and to adopt other measures with a view to further enhancing labor mobility.

Directors welcomed the authorities' "innovation pillar" and additional efforts to reduce red tape to promote productivity growth. Noting that barriers to entrepreneurship and product market regulation remain relatively high, Directors recommended careful liberalization to facilitate the emergence of innovative firms, which can make greater use of productivity-enhancing information technologies.

Directors observed that the Dutch financial system is healthy and well poised to weather the global turmoil, and they strongly welcomed the enhanced supervisory and regulatory framework. In view of growing risks associated with cross-border financial integration and increased use of structured products, Directors underscored the importance of strengthening cooperation and information-sharing among supervisors in home and host countries, as well as transparency in reporting complex products, while increasing cost efficiency and equity capital.

Directors noted the staff's assessment that overvaluation of the Dutch housing market is only minor, while stressing that high household mortgage indebtedness, and house price developments in general, warrant careful monitoring. They saw benefit in regulatory action to reduce high loan-to-value ratios, improve the measurement of related collateral, and fine-tune capital requirements for loans with different risks. Gradual removal of mortgage interest deductibility would contribute to decrease loan-to-value ratios, thereby lowering households' vulnerability to house price swings and interest rate shocks.

Directors commended the authorities' continued commitment to high levels of Official Development Assistance.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.