Norway -- 2003 IMF Article IV Consultation, Concluding Statement
December 9, 2003
A strong macroeconomic policy framework has underpinned enviable prosperity and a high degree of social equity in Norway. Real incomes are among the highest in the world; employment is high and unemployment low; and petroleum revenues ensure large current account and fiscal surpluses for several years to come. The fiscal guidelines adopted in 2001 form the basis of a reasonable compromise between the current and future use of oil revenues. Operationally, they can constrain spending and, consequently, pressures for real exchange rate appreciation that would damage the exposed sector. Finally, the inflation targeting framework contributes to economic stability and helps to guide expectations in labor and financial markets.
Economic growth fell sharply this year, but activity appears to be picking up again. The slowdown reflected economic weakness in Norway's trading partners, as well as tight monetary conditions last year in the context of strong wage growth and prospects of further fiscal expansion. In the course of 2003, as inflationary and wage pressures eased significantly, the central bank aggressively and appropriately cut interest rates. Households are now beginning to respond by raising consumption. The interest rate cuts also reversed the krone appreciation which, together with the improving world economic outlook, should boost the exposed sector in the coming months.
Prospects for a recovery in 2004 are good. Wage growth is widely expected to remain low, and although core inflation will rise as the recent krone depreciation passes through to domestic prices, the 2.5 percent inflation target is unlikely to be exceeded. The policy of maintaining a supportive monetary stance for the time being is therefore appropriate. On current projections, monetary policy will have to move toward a more neutral stance as the recovery takes hold.
Robust growth will depend on the social partners contributing to a benign inflation outlook. Continued wage moderation will be key, and in this regard the apparent return to the traditional bargaining pattern, with the exposed sector taking the lead, gives reason for optimism. Another important factor will be a prudent fiscal policy that preserves the credibility of the fiscal guidelines and forestalls pressures that could lead to real exchange rate appreciation. The sustained increases in housing prices would pose a threat to domestic demand if they were to reverse abruptly. Disappointing world growth or large falls in oil prices would also dampen growth.
Against the backdrop of strengthening economic activity, policy makers face a number of challenges in the years ahead. A commitment to control spending and non-oil deficits is the key to a strong fiscal position, while measures also need to be taken soon to reform pensions. The monetary policy framework will be strengthened by recent institutional changes, although the mandate should be clarified. On the structural side, strong labor market performance would be bolstered by ensuring adequate work incentives, and productivity enhanced by promoting dynamic product markets able to exploit new opportunities.
The authorities have made commendable efforts to adhere to the fiscal guidelines in the face of demands for greater expansion. In 2004, however, the non-oil structural balance is set to deteriorate somewhat, implying a procyclical stance and a further deviation from the rule that restricts the central government structural non-oil budget deficit to 4 percent of the assets in the petroleum fund. The credibility of this rule risks being undermined. It has not been met in the past, in part due to unusual circumstances, and on current plans will not be achieved until 2009. In addition, tax reforms to be proposed next year seem likely to reduce revenues and thus need to be coupled with spending restraint to avoid further fiscal deterioration. In this light, it would be wise to bolster credibility by taking advantage of the coming economic expansion to move toward the 4 percent rule more rapidly than now envisaged.
There is scope to buttress the fiscal guidelines. The automatic stabilizers should continue to operate, but discretionary countercyclical policy should be foregone. This would reduce the temptation for asymmetric policies that would, over time, enlarge the deficit. More importantly, with inflation targeting, discretionary fiscal expansion would tend to be offset by monetary policy, resulting in an undesirable policy mix of high interest rates and a strong currency. Consideration should also be given to introducing a binding expenditure rule, as some other countries have done, with a view to ensuring room for desirable tax cuts consistent with adhering to the 4 percent rule.
Pension reform may be the most important policy decision facing Norway. Given current pension programs, public spending will rise considerably in the decades ahead as the population ages. Norway has the advantage of the petroleum fund, and the fact that future pension payments depend on these assets should be made clear by formally linking the fund to the pension system. However, the petroleum fund will not be enough, because current and future oil revenues will fall far short of future pension needs. The work of the pension commission, which is to report soon, is therefore welcome. We would recommend a number of reforms to enhance long-term fiscal sustainability and labor supply: price, rather than wage, indexation of benefits, which is the most promising avenue to save costs; linking eligibility or benefits to increases in life expectancy; broadening the base of the benefit calculation to lifetime earnings; and enhancing incentives to stay in work, including by making the system actuarially fair and by reforming the public-sector pension system.
The flexible inflation targeting framework is well suited to the small, open Norwegian economy. Under this approach, monetary policy targets core inflation at a two-year horizon, which may be changed in exceptional cases, and thus helps to reduce short-term variability in output and exchange rates. Adding objectives to monetary policy beyond inflation would only cloud markets' perception of policy intentions. For the same reason, the reference to stabilizing the exchange rate should be dropped from the mandate. Recent reforms to further strengthen policy formulation and implementation are commendable. Regular hearings before parliament with the governor of Norges Bank-the first one was last week-will increase monetary policy transparency. Such parliamentary oversight is particularly appropriate in an inflation targeting framework, since the central bank has considerable autonomy and responsibility to pursue the target. The new procedure for choosing bank board members will enhance independence and expertise at the highest policy making levels. And regular outside policy reviews will promote best practices.
The financial sector appears to have dealt well with the economic downturn. While higher loan losses have reduced profits, they have been well contained. The overall health of the banking sector, as measured by indicators such as return on equity and capital adequacy, remains strong. An abrupt decline in house prices, should it occur, would hurt aggregate demand and thus raise losses on business loans. The implementation of the Basel II capital requirements will improve the financial position of Norwegian banks, which have a relatively high proportion of low-risk assets. However, as capital requirements will be generally leaner, both financial institutions and supervisors will have to exercise close oversight.
Norwegian labor markets perform very well by international comparison, and the challenge will be to maintain, and even improve, this situation in the years ahead. Of immediate concern is the rapid uptake of sickness and disability benefits, which erodes labor supply and is costly to the budget. Recent initiatives to tighten eligibility for disability benefits and to move people more rapidly from sickness to rehabilitation are welcome, but are unlikely to be sufficient. Norway has one of the lowest average working hours among advanced economies. While to some extent this reflects individual choice, high labor tax rates pose a significant disincentive to work longer hours. Substantial cuts in tax rates thus hold some promise, and should be accompanied by appropriate spending control.
Dynamic product markets will be the key to strong long-term productivity growth. The government can contribute by ensuring an efficient and neutral tax system. Taxation of property, which is low in relation to that on other forms of capital in Norway and by international standards, should be raised, and the extra revenue used to cut labor taxes. The government can also improve product market performance by streamlining the regulatory framework, and recent progress in this area is welcome. Supervisory agencies are gaining greater operational independence and their roles are being clarified. The competition agency is to be strengthened, in large part reflecting the parallel devolution of authority in the European Union. More rapid reduction in the government's large ownership position in the economy would be desirable, and expensive subsidies to agriculture should be re-evaluated.
Norway's substantial commitment of official development assistance, which exceeds the United Nations target of 0.7 percent of GNP, is commendable.
Oslo, December 9, 2003