Kingdom of the Netherlands-The Netherlands -- 2003 Article IV Consultation, Preliminary Conclusions
May 19, 2003
The cyclical slowdown of the Dutch economy continued into 2003, as real GDP declined in the first quarter according to preliminary estimates, and unemployment rose further. The sources of the prolonged weakness are clear, and in part reflect a necessary unwinding of imbalances that built up in the economic boom of the late 1990s. Business investment has been falling since late 2000. Household wealth and consumption growth were cut sharply by the end of rapid house price increases and the collapse of equity markets; the latter also weakened corporate balance sheets. Exports fell as well, mainly due to the worldwide economic slowdown, but additionally because high wage and price inflation during the boom period eroded international competitiveness.
Looking forward, there are reasons to be cautiously optimistic, but also evident risks. We expect growth to rise gradually later this year, and to strengthen further in 2004. Most forecasters expect past monetary easing and the clearing of investment overhangs to result in a pickup in the world economy in the next several quarters. Domestically, wage and price inflation have fallen significantly, reflecting much softer market conditions and the cooperative and responsible attitude of the social partners; continued wage moderation will be important in the years ahead. Yet there are downside risks. The world recovery may be delayed; there are still no concrete indications of an upturn, and in most advanced countries consumer and business confidence remain low. Adverse effects of the euro appreciation, though of uncertain magnitude, have not yet been fully felt and, in the Netherlands, significant falls in house prices cannot be ruled out.
Against the backdrop of these difficult conditions and uncertain prospects, the government should adopt economic policies to restore confidence, lay the foundation for stronger growth in the years ahead, and deal with population aging. We have not had the time to assess the measures in the coalition agreement released last Friday, but the new government's resolve to address key issues, notably the public finances, is clear.
The fiscal position has deteriorated markedly due to both cyclical and structural factors. On current economic projections, the general government deficit is likely to be about 1¾ percent of GDP this year. In the absence of policy measures, it could rise to some 2½ percent of GDP in 2004, with prospects for substantial, though declining, deficits during the entire coalition period. This outlook contrasts sharply with last year's projections of increasing fiscal surpluses.
In the coming period, fiscal policy should continue to be oriented to the long-term goals of providing for population aging and enhancing the growth potential of the economy. Measures in the 2003 budget are welcome, as they will forestall a widening of the structural balance while allowing the automatic stabilizers to play. For 2004, further measures are warranted to contain the prospective rise in the deficit and to begin the process of restoring a strong structural budget position. By the end of the coalition period, a structural surplus should be built up, broadly in line with last year's recommendations of the Study Group on the Budget Margin. At the same time, consideration needs to be given to pension, disability, and health-care reform to curb the rising costs associated with population aging and create room for growth-enhancing tax cuts.
Improving the underlying fiscal position will require tight spending control. The coalition agreement envisages several initiatives, including measures to contain social spending, restrain civil service pay, and raise public sector efficiency. The erosion of the tax base, which reflects in part structural factors, needs to be reversed. Narrowing, and ultimately eliminating, the tax deductibility of mortgage interest would be useful, and the coalition agreement takes a step in this direction. The agreement also includes a welcome initiative to eliminate the tax deductibility of prepension contributions.
The very large rises in health care spending in the past two years, reflecting a shift from strict budgetary envelopes to a more demand-driven system, are of particular concern. Increasing deductibles and copayments, and narrowing the scope of care covered would blunt pressures in this area. These measures may not be sufficient, however, and we therefore welcome the suggestion in the coalition agreement that reimposition of budgetary controls would be considered if necessary. The new government also intends to introduce sweeping reforms which hold the promise of increasing efficiency and responsiveness to patients' needs. However, it is far from clear that the new structure will adequately control costs arising from demand pressures. Recent experience illustrates the risks in this regard.
The new multi-year fiscal framework will bolster fiscal discipline and policy transparency. The key features of past frameworks—real expenditure ceilings and the strict separation of revenue and spending decisions—have been retained. In view of uncertain medium-term economic prospects, it will be particularly important to devote to deficit reduction unanticipated windfalls on the revenue side, as proposed in the coalition agreement, and also on the spending side.
A strength of the Dutch pension system is the substantial and well established second pillar. The collapse in the stock market, however, has uncovered problems of underfunding. The prompt action by the pension supervisor to address this issue was appropriate. Proposals to improve risk management, supervision, and transparency in this field are welcome. Cost-reducing reforms should also be considered, such as limiting indexation, moving further to average-earnings schemes, and raising the age of pension eligibility in light of longer life expectancies.
The current weakness of the Dutch economy has raised concerns about longer-term growth prospects. While the Netherlands enjoys comparatively strong labor-market outcomes, weaknesses remain, notably the disability program, relatively low participation of older people, and poverty and unemployment traps. Efforts on a broad front to increase employment rates are therefore of great urgency, not least to ease the problems associated with population aging.
Reform of the disability scheme, which has beneficiaries equivalent to about 13 percent of employment, has long been on the political agenda. The authorities' policy of first implementing measures to reduce inflows, such as restricting eligibility to the fully disabled and eliminating the customary top-up payments, is prudent. Only after satisfactory results have been assured should consideration be given to other parts of last year's SER advice, such as abolishing experience rating (PEMBA) or raising replacement rates. Indeed, should the measures now proposed fail to reduce inflows enough, further action will be necessary, notably cutting the replacement rate.
Recent initiatives to raise the labor-force participation of older workers are welcome. Introducing a job-search requirement for unemployment benefits for those over 57½ years old should encourage reintegration. The replacement of VUT early retirement schemes by flexible prepensions, which are more actuarially fair, will strengthen work incentives. Fully integrating early retirement and second pillar schemes so entitlements can be built up to 65 years of age, and beyond (forward flexibility) would further encourage people to stay in work. And eliminating the subsidy to early retirement by abolishing the tax deductibility of contributions should prove helpful.
Reducing poverty traps and enhancing labor-market reintegration will require considerable effort on a number of fronts, especially in view of high implicit marginal tax rates at low earnings levels. The government's intention to reduce rent subsidies is therefore encouraging. The increased role of block grants to municipalites should sharpen their financial incentives to integrate those out of work.
The new government needs to reinvigorate the agenda for product market reform in order to raise productivity growth. Public skepticism has risen, in part because some well publicized reforms, in the Netherlands and elsewhere, have had mixed outcomes at best. Thus, to build public support the authorities will have to ensure both that the benefits to consumers are significant, which may require regulation, and that these benefits are well understood. There are successes to build on. Electricity liberalization has already reduced costs for medium-sized firms, and the administrative burden has fallen, though more needs to be done.
The economic slowdown has reduced profits and weakened balance sheets in the financial sector. Nevertheless, banks remain adequately capitalized and are successfully implementing cost-cutting measures. The sector appears well positioned to weather further possible adverse developments, including a substantial fall in real estate prices. The merger of bank and insurance/pension supervisors should further strengthen oversight of large conglomerates and pension funds. Care will be needed to minimize overlap and duplication, and to smooth the integration of the supervisors at management and working levels. The way for the latter was paved by cross appointments of senior personnel from the two institutions.
We commend the authorities' support for multilateral trade liberalization, the high level of development assistance—which, at 0.8 percent of GNP exceeds the UN target—and innovations in the delivery of development assistance which emphasize ownership by recipient countries and focus on sectoral policies.
The Hague, May 19, 2003