Concluding Remarks of 1999 Article IV Consultation -- Norway
October 26, 1999
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Norway—1999 Article IV Consultation
Concluding Statement of the Mission
October 26, 1999
1. The current slowdown in the Norwegian economy has followed an exceptionally prolonged phase of expansion lasting over five years. The fruits of this sustained expansion have been evident in major—and broadly shared—gains in employment and real incomes. Indeed, in notable contrast to many European countries, Norway has succeeded in achieving both virtual full employment and a sharp rise in the participation rate. At the same time, price inflation has remained low. The authorities' economic strategy based on the Solidarity Alternative has contributed to this exemplary record. The strategy has been anchored in exchange rate stability and an impressive fiscal consolidation, and has been underpinned by cooperation between the social partners. The policy of reinvesting abroad a substantial part of the oil revenues through the State Petroleum Fund has helped to insulate the mainland (non-oil) economy from developments in the oil sector.
2. The strategy suffered considerable strains last year in the face of large wage settlements made possible by the excess demand conditions and an insufficiently restrictive fiscal stance. These strains, combined with the effects of the sharp fall in oil prices, were most visible in the need for Norges Bank to raise sharply its policy interest rates to stem the fall of the krone. The slowdown in activity which began in late 1998, primarily driven by a contraction in investment, is not entirely unwelcome. A cooling-off period was needed after years of rapid growth had propelled mainland output to a level that was significantly above the economy's productive potential. Indeed, despite the slowdown, the mainland economy at present continues to operate above the estimated level of its potential output. Signs of continued constraints on resources are apparent in the high levels of capacity utilization and persistent shortages of labor in the sheltered sector.
3. The current pause in economic growth is expected to continue into 2000, with investment contracting sharply. But with private consumption growing robustly in response to continued healthy growth in household income, and petroleum exports rebounding, a soft landing is in prospect. Indeed, the risks to this scenario, in our view, are primarily on the upside. With high household saving and wealth positions, a pick-up in consumer confidence, and improved market prospects for traditional exports, demand and activity may well be stronger next year than now projected.
4. Despite a subdued outlook for growth in the mainland economy, a variety of indicators point to continued tightness in the labor market. This mixed economic outlook suggests that a neutral fiscal stance for 2000 would be appropriate. However, if activity appears to be stronger into next year than now expected and labor market conditions remain tight, a restrictive stance in the revised budget in May might well be needed. The recently proposed state budget for 2000 implies a neutral fiscal stance as measured by the change in the cyclically adjusted non-oil balance, excluding net interest payments. We believe that the focus of fiscal policy from a demand management standpoint properly belongs at the level of the general government. Given the undoing of the contractionary fiscal stance at the central government level by excessive spending incurred by local governments in 1998, it is all the more important to aim for a neutral overall fiscal stance. Recurring overruns in expenditures have been a feature of budgetary outturns of recent years. In order to ensure the desired fiscal stance for the general government, therefore, it is critical to contain expenditures within the budgeted amounts both at the state and local levels. Failure to do so could risk repeating the unpleasant experience of last year when markets and private agents reacted adversely, in part to the signals coming from a fiscal stance viewed as inconsistent with the state of the economy.
5. Monetary policy has faced difficult challenges in the recent past. The increased emphasis in Norges Bank's conduct of monetary policy toward greater tolerance of short-term deviations of the exchange rate from its implicit target range is welcome. It recognizes the reality that trying to maintain the exchange rate within narrow limits entails heavy costs. This emphasis allows for greater scope for discretionary monetary policy to bring inflation down to the level prevailing among the main trading partners. This orientation will help limit adverse market speculation when the krone strays from its implicit target band. The sustained efforts of Norges Bank to clarify the policy framework and educate the public are to be commended. We believe, however, that the transparency and credibility of the monetary regime in Norway would be enhanced by a mandate from the government that accords explicit recognition to the objective of low and stable inflation as the pre-condition for long-run exchange rate stability. Formalizing such a mandate would remove the lingering uncertainty about current and future monetary policy actions. It would also provide a transparent foundation for the economic policy framework over the medium term.
6. The gradual and cautious approach to easing monetary policy followed over the past year should continue, given the upside risks to activity and inflation. Monetary policy should guard against a pickup in inflation either on account of domestic cost pressures or because of an unexpected rise in import prices. If fiscal and incomes policies play their parts in bringing about a durable change in inflation, interest rates can gradually be brought down in the period ahead. The longer term objective of exchange rate stability is only credible as long as wages in the exposed sector are competitive and wage growth in the rest of the economy does not undermine low inflation. Once inflation is brought down to the level in the main trading partners, it would be the task of fiscal and incomes policies to ensure stable employment and income growth.
7. The strains suffered by the Solidarity Alternative last year hold valuable lessons for the coming year. The imbalances in the labor market and the rapid wage growth on average in 1998-99—almost double that in the main trading partners—suggest that the policy framework will face a renewed test in the major wage negotiations next spring. Limiting wage increases to the projected growth in wages among the main trading partners is appropriate, but this should not be achieved by the government committing itself to generous social and labor market programs, as in the past. These programs, while entailing only modest costs in the short run, can be expensive to the budget in the long run. A gradual accretion to non-wage costs can also be harmful to the competitiveness of the exposed sector in the medium term.
8. Over the longer term, public finances face challenges as oil revenues begin to run out and pension liabilities escalate due to demographic trends which will sharply reduce the number of economically active Norwegians in relation to the number of pensioners. The recent sharp increases in early retirement programs and in pension benefits have already added to these potential fiscal pressures. Future growth in the relative importance of early retirees and those on disability benefits would put further strains on the system. While the State Petroleum Fund provides a cushion against these future liabilities unlike in other advanced economies facing similar pressures, there is a large risk of complacency. The authorities' current strategy to provide a comprehensive public pension to all citizens may prove unsustainable in the long term unless strict discipline with respect to eligibility and the level of pension benefits is imposed. An attractive option, noted in the Moland Committee's report on pensions, would be to move to a system under which a publicly financed basic pension is supplemented by private defined contribution plans. The present situation of a relatively low old-age dependency ratio and the large buffer provided by financial assets provides a clear opportunity to launch such an initiative.
9. As Norway begins to contemplate its post-oil future in a globalized world economy, the task of designing an incentive structure to promote an internationally competitive, knowledge-based economy assumes growing importance. While in the past, Norwegians have accepted a relatively heavy tax burden to pay for a large public sector, the costs of this choice are likely to rise in the future. Restraint on public expenditure would allow a gradual reduction in the tax burden which is substantially above the average level in the advanced countries. At a minimum, incentives to work, save and invest could be improved by raising the low thresholds for income and wealth taxes, and eliminating the investment tax. A partial revenue offset would be possible through broadening the tax base inter alia by eliminating some of the many tax preferences. In this respect, an early consideration of the proposal to extend the value-added tax to cover services would be welcome. The authorities are to be commended for enhancing fiscal transparency by publishing an exhaustive list of tax preferences in the 2000 budget. This should serve as a basis for an informed debate on this issue in the period ahead.
10. In any attempt to review and rationalize public expenditures over the medium-term, an overhaul of the regime of support to agriculture deserves high priority. The extensive system of subsidy and regulation for agriculture designed to produce a wide variety of farm products has led to one of the highest levels of agricultural subsidization in the world, almost double that in the European Union. Clearly, the regional and social objectives of the support program could be sought through economically less costly and distortive measures. Such a reform of the regime would be consistent with Norway's generally rational approach to economic management.
11. The success of the incomes policy framework and the elastic labor supply have contributed to an exceptional performance of the labor market in recent years with strong employment growth and low unemployment. There is, nevertheless, scope to improve this performance by liberalizing labor market regulations and allowing for greater wage differentiation. An early passage of the amendment to the Employment Act to ease regulations on hiring would be desirable. Consideration should also be given to reducing the limitations on the use of overtime. Such reforms would provide proper work and education incentives, reduce bottlenecks, and help sustain the rate of unemployment close to its current level.
12. Norway's banking sector has recovered well from the crisis suffered in the early 1990s with strengthened and effective oversight by the supervisory authorities. Capital adequacy ratios are high, loan losses are low, and profitability of the sector is high. The continued vigilance being demonstrated by the supervisory authorities against the emergence of new risks is however appropriate. Although there are no grounds for immediate concerns, it would be important to continue monitoring real estate prices for any signs of a bubble that could create risks for the financial system in the event of a negative shock.
13. The privatization initiatives in the banking and telecommunications sectors are commendable, and we would encourage a reduction in public ownership in the petroleum sector as well. These initiatives will help improve efficiency and corporate governance in these sectors. Public ownership, especially in the financial sector where it is partly a legacy of the banking crisis, can be an impediment to exploiting fully the efficiency gains offered by restructuring and growth possibilities. If the government retains some ownership, it should ensure that the enterprises are run on the basis of commercial principles without government interference. This will ensure that Norway is not left behind in a world of rapid changes in innovation and increased competitive pressures.