Mission Concluding Statements
Norway and the IMF
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INTERNATIONAL MONETARY FUND
Norway—2002 Article IV Consultation
December 11, 2002
1. The Norwegian economy has displayed remarkable resilience during the past year. Despite adverse external influences from a weak global economy, growth in the mainland (non-oil) economy in 2002 is on course to exceed that recorded a year earlier. Inflation has remained low, and fiscal and external surpluses continue to be large and robust. Much of this success can be credited to sound economic policies and prudent resource management, including the policy of saving and investing abroad a large part of the revenue from petroleum, currently near peak levels. The new long-term fiscal program put in place last year has helped to clarify the parameters of the policy regime and has been wisely complemented by the adoption of an inflation targeting framework, affirming the commitment to maintain low and stable inflation. The Government's announced resolve to bring about a lasting reduction in the high tax burden holds the promise of improving the supply potential of the economy.
2. The new macroeconomic policy regime has shaped the economy's recent evolution, with greater use of oil revenues accelerating the pressures on the exposed sector. The program of medium-term fiscal expansion has contributed to significant appreciation of the real exchange rate, although only partly through its direct stimulatory impact on aggregate demand. The decision to use more oil revenue now, despite large unfunded public pension liabilities, may have reinforced popular overestimation of national wealth, thereby lifting private consumption. More damagingly, such euphoria appears to have adversely affected the wage bargaining process, leading to excessive wage demands, especially in the public sector. The resulting large income gains may have fortuitously helped sustain growth in the Norwegian economy this year, while many other economies slipped. However, the excessive wage inflation and fiscal stimulus have inevitably required high real interest rates, dampening the outlook for mainland investment. Moreover, Norway's relative economic strength and the increased interest differential, combined with other factors such as the rise in oil prices, have pushed up the external value of the krone, intensifying pressures on industries exposed to international competition.
3. The fallout from the global slowdown is expected to be temporary, but the process of economic restructuring is bound to continue. The international downturn has stretched beyond expectations, auguring poorly for the near-term. So far, domestic demand in Norway has held up, and layoffs have been mostly contained to some service sectors retrenching from global overcapacity. A rise in manufacturing unemployment can be expected, however, as companies gradually adjust to their depressed profitability. The current consensus is for a global recovery to take hold by mid-2003, barring unforeseen shocks stemming from geopolitical developments. A rebound in activity would add to the already high level of domestic resource utilization in Norway. The macroeconomic policy mix will continue to exacerbate the strains on the exposed sector, while the sheltered sector thrives. Weaker domestic price pressures in the short-run and lower import prices, partly due to the lagged pass-through of the strong krone, should help ease inflation, at least until the global economy rebounds.
4. The authorities deserve to be commended for broadly adhering to the fiscal rule in framing the budget for 2003, despite significant pressures to increase further the non-oil fiscal deficit. Deviation from the fiscal guidelines, soon after their adoption, would not only have undermined the credibility of the policy framework, but raised the required level of interest rates consistent with the inflation target, and put long-term public finances at increasing risk. Arguably, a small fiscal contraction consistent with a strict adherence to the fiscal rule would have helped relieve pressure on real interest rates. In any case, as discussed last year, we believe that the fiscal rule is already too expansionary given the magnitude of the public pension obligations and other prospective age-related spending pressures over the longer run. Therefore, a clear and consistent implementation of the fiscal guidelines is essential. Attempts to deviate from the stipulated structural deficit path in an asymmetric fashion or to smooth, and thereby accommodate, previous fiscal slippages risk eroding Government Petroleum Fund (GPF) balances and undermining the discipline of the fiscal rule. Thus, it is necessary to clarify the precise conditions allowing for deviation from the fiscal rule (i.e., the non-oil structural fiscal deficit of the central government must correspond to the expected real return of 4 percent on the GPF). The clarification should include specifying both the threshold for changes in the market value of the GPF beyond which a deviation from the fiscal rule is permitted as well as the timeframe for smoothing the budgetary impact of such changes. Finally, the fiscal rule should continue to be implemented by using a consistent and transparent definition of the structural balance.
5. Some scope for easing monetary policy is emerging, as lower import prices and subdued activity are likely to bring medium-term inflation below the target. The stance of monetary policy maintained by Norges Bank this year has been appropriate, given the fiscal stimulus in place and the unexpectedly high outcome of the spring wage round. Indeed, a relatively high level of interest rates, while unlikely to be popular, will continue to be needed to ensure low and stable inflation in the context of the decision to phase in greater use of the oil wealth. Looking ahead, the lackluster global economic environment may well have a further adverse impact on the Norwegian economy. Moreover, rising unemployment, flagging consumer confidence, and gradually slowing credit growth also point to reduced steam in the domestic economy and, therefore, room for easing the monetary stance. However, the scope for lowering interest rates would be undermined if social partners were to engage in another round of excessive wage increases in the coming year.
6. Norges Bank's operation of inflation targeting has drawn on best international practice, but further improvements to the framework would be desirable. We support continued measures to enhance transparency and therefore welcome intentions to publish the Strategy Documents (Strateginotat) ex-post. Consideration should be given to publishing these documents concurrently with the Inflation Report, so as to communicate Norges Bank's view of the most likely path of interest rates and alternative assumptions for the exchange rate. The formal accountability of Norges Bank could be improved, for example, by introducing regular independent expert reviews and parliamentary hearings on the conduct of monetary policy. Also, the process of nominating members to the Executive Board could be depoliticized and the appointment of professionals with suitable expertise encouraged. Most importantly, the reference to exchange rate stability in the monetary policy regulation continues to be a source of popular confusion and serves to divert public attention from the inflation objective. The reference should therefore be deleted at the earliest convenience, perhaps in the context of a further refinement of the monetary framework.
7. How pension reform and the related issue of the use of petroleum wealth is addressed will determine the success of the authorities' economic policy in the long run. The current attention on distributional effects of alternative pension options following the preliminary report of the Pension Commission is of course natural. Indeed, any option would have to guarantee minimum income after retirement. However, it needs to be recognized that the current public pension system is not financially viable, even with the Petroleum Fund. In the context of longer life spans and the trend decline in average retirement age, the generous pensions of upcoming retirees can be supported only by a sharp increase in contribution rates of wage earners, which is implausible given the already high level of taxation in Norway. Thus, a key objective of a comprehensive pension reform should be to ensure that the system is financially self-sustaining. This could be achieved, for instance, by raising the average effective retirement age or by indexing benefits to prices rather than wages. Using the Petroleum Fund to help fund the pension system would have the advantage of preventing public wealth from being spent for other purposes before the coming escalation of age-related spending begins. This, however, would not address the intergenerational inequity of the current pension system. Reform should also address the disincentive effects of the current pension and tax regimes on labor supply. For instance, while provisions for early retirement may be desirable, rewards should be provided for those who wish to continue to work. Finally, the options for providing an element of private choice in annual savings should be carefully studied, including their implications for administrative costs, capital market development, and macroeconomic effects.
8. Changes in tax policy should focus on measures to raise growth and economic efficiency. Norway's dual income tax system is generally neutral and supportive of investment. However, in recent years, ad hoc changes in the tax system have been put in place in response to specific concerns, for instance, regarding rising cross-border purchases. It is to be hoped that the Tax Committee will provide a comprehensive framework for improving the system, including a restoration of the principles of the 1992 reform. For example, the tax bias that encourages accumulation of wealth in the form of housing, rather than productive capital, should be eliminated. In addition, the high tax burden on labor income should be reduced to boost incentives to work, increase returns to education, and reduce the opportunities for tax avoidance associated with the split income model.
9. Strong efforts to stem expenditure pressures and improve the efficiency of the public sector are imperative. Rapid expenditure growth, due to the high take-up of transfer schemes, and political pressure to increase the scope of the welfare state, could absorb future budgetary increases in the use of petroleum revenue and risk derailing the opportunity to lower Norway's high tax burden. Such spending growth would also likely intensify the stimulatory effects of the planned fiscal expansion and lead to higher interest and exchange rates as compared with tax cuts aimed at increasing potential growth. Multiyear budgeting and expenditure ceilings could provide one means of controlling expenditure growth. Moreover, increasing the efficiency of the public sector—including by improving pricing mechanisms and ensuring performance-oriented financial management and salary structures—would be a more durable way to increase delivery of public services.
10. Restoration of Norway's earlier tradition of wage moderation would be in the interest of all segments of society. Restraint in wage claims would ease the required level of interest rates, and thereby also reduce pressure on the exchange rate. Wages in the private sector should be set with an eye to maintaining the growth of unit labor costs in line with that in trading partners, and indeed some additional efforts are required to reverse the significant loss of competitiveness suffered over the past several years. The lead role of exposed industries in the bargaining process should thus be safeguarded. It is especially critical for public sector employees to refrain from exorbitant wage demands—unrelated to demonstrable improvements in their efficiency—not only to help contain domestic price pressures, but to ensure that some of the growth in public sector outlays is translated into real increases in services to the public.
11. Labor market policies should aim at increasing effective labor supply, ensuring employment and wage flexibility, and providing incentives for a smooth economic transition. Despite a high labor participation rate, hours worked are low and falling as the take-up of sickness leave, disability and early retirement grows rapidly. Labor shortages will likely remain a binding constraint on growth in the years ahead. Measures underway to reform unemployment benefits, disability pensions, and vocational rehabilitation schemes, to liberalize immigration policy, and to ease working time regulations can help alleviate these shortages. In addition, economic incentives or tighter eligibility criteria would be required to lower sick leave, as the voluntary agreement among the social partners has failed to stem the sharp rise in the take-up of sickness benefits.
12. Continued structural reforms will be essential for raising potential growth and alleviating the strains of economic restructuring. The petroleum sector will contribute to impressive current account balances over the medium-term, but the current peak levels of production are expected to dwindle sharply over the next several decades. Moreover, industries exposed to international competition—which are a key source of technological advancement and spillover from abroad—are already beleaguered. Thus, product market reform will be indispensable to help spur private sector initiative and dynamism, and should include continued progress in deregulation and reducing the high level of public ownership.
13. The financial system appears sound, although the outlook for its stability has deteriorated somewhat. Sustained, rapid growth in credit to the mainland sector has resulted in higher debt levels of both enterprises and households. In the enterprise sector, the global downturn, high domestic interest rates and falling profitability have contributed to rising debt and interest burdens, with the former reaching the level that prevailed during the banking crisis of the early 1990s. Although bank profits have declined, loan losses remain low, capital adequacy has improved, and the banks' overall financial position appears sound. The authorities are alert to emerging risks and are monitoring the financial system closely, actively using stress testing to assess vulnerabilities, such as to a potential decline in property prices. Given the prolonged rapid growth of credit, the sharp appreciation of the krone and increased uncertainty about the economic outlook, stress tests should also examine the impact of an unexpected sharp downturn, leading to a rise in unemployment and a further weakening of profitability in the exposed sector.
14. A reduction in the budgetary and trade protection to agriculture is long overdue. Norway's agricultural sector remains heavily protected from international trade and enjoys substantial subsidies linked to output, with the share of farm income derived from support measures exceeding even the European Union average. These policies impose high costs on Norwegian consumers and taxpayers. A reduction in subsidies and trade protection to agriculture would help exports of farm products from developing countries, an outcome which would aptly complement Norway's generous official development assistance.
IMF EXTERNAL RELATIONS DEPARTMENT