Kingdom of the Netherlands -- The Netherlands: 2006 Article IV Consultations, Preliminary Conclusions of the IMF mission
May 9, 2006
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
1. There is reason to be glad. The economic recovery is gathering steam, broadening to the domestic components of economic activity. More generally, the Dutch approach to social policy—while not without need of more reform to, for example, raise labor participation further—brings to all its citizens the benefits of the country's high living standard and level of productivity.
2. Dealing with key challenges is nevertheless essential for ensuring a solid foundation for sustaining economic growth over the medium and longer term. Among the key challenges is making sure that the public finances are sustainable in the face of population aging. In addition to raising participation further, which would help to deal with aging, it is also important to undertake further structural reforms to raise overall productivity growth. Without deeper reforms to raise participation and productivity, potential growth in the Netherlands could get stuck at a low rate, in circumstances in which it would also be pulled down by an aging population. Dutch capabilities to deal with significant challenges have clearly been in evidence in the remarkable achievements over the past few years: just to name some of them, reform of health care, disability, and financial supervision, the successes in strengthening the administration of social benefits as a result of improving incentives for local authorities in administering them, and the turnaround in the public finances (while, it should be noted, maintaining the commitment to the United Nations' target for overseas development assistance).
The Near-Term Setting
3. After a period of slow or negative growth, a recovery is taking hold. Average annual growth in 2001-03 was only ½ percent, the slowest rate in any three-year period since the beginning of the 1980s. A worsening of external competitiveness, combined with weak foreign demand, restrained exports and growth overall. However, more robust foreign demand since then has given a considerable boost to the recovery. Thus, largely driven by the contribution of net exports, overall growth rose significantly in the second half of 2005—though this was probably tempered by the lagged effects of earlier losses in competitiveness from wage increases and exchange rate appreciation. Importantly, the growth of private consumption and investment gained traction in the second half of 2005, consumer and business confidence have been strengthening, and quarterly employment started to rise in 2005 for the first time since 2001. In addition, moderate wage increases in 2004 and 2005, along with some depreciation of the euro, also halted and started to reverse the decline in competitiveness—a positive development for export prospects.
4. Against this background, growth should continue to pick up. Growing employment bodes well for private consumption. Further improvements in competitiveness supported by wage moderation should help exports in circumstances in which foreign demand is expected to be strong. Meanwhile, stronger corporate balance sheets alongside export growth are among the factors supporting higher investment. In all, our baseline is not dissimilar to official forecasts and projects growth of 2.6 percent in 2006 and 2.8 percent in 2007. It is important to stress that continued wage moderation to support external competitiveness would allow the Netherlands to take full advantage of the global upturn. While perhaps not an immediate near-term issue, this could take on increasing importance as the recovery gathers force.
5. Of course, there are risks that bear watching. Higher-than-expected oil prices, a significant appreciation of the euro, and slower-than-expected growth of trading partners are factors that could dampen the strength of the upswing. Indeed, the main reason why the mission's projection for economic growth is lower than the official forecasts of the Netherlands (which were made earlier) is because of a higher level of oil prices this year and next. In addition, a possible interest rate led house price decline could negatively affect consumption, including because some households with high debt are particularly vulnerable. At the same time, however, the behavior of private consumption is highly uncertain, with a considerable upside in the face of a strengthening economy.
6. The fiscal adjustment of the past two years was impressive. With an eye to contributing to fiscal sustainability and resilience to population aging, Fund staff had recommended cumulative fiscal adjustment in structural terms for the general government balance (also called the EMU balance) of at least 2 percentage points of GDP during the current government's term. In fact, after breaching the Maastricht deficit ceiling in 2003, the deficit narrowed to 0.3 percent of GDP in 2005. This reflected structural adjustment of about 2½ percentage points of GDP, an extraordinary effort against a background of lackluster economic activity. While tightening of this magnitude may not have been ideal in the face of some weakness in economic activity, the risks were, in the mission's view, acceptable. In this connection, the marked deterioration in the public finances during 2000-03 contributed to declining confidence. Though difficult to quantify, subsequent fiscal consolidation likely helped reverse this, especially in circumstances in which it was well recognized that consolidation was needed to prepare for aging. Moreover, with the impact on activity also likely to have been moderate for a small open economy like the Netherlands, and benefits from upfront adjustment in light of the election cycle and aging, the mission welcomes the policy that was pursued.
Fiscal Policy in the Years Ahead
7. The mission would recommend that the government, during the remainder of its term, safeguard the magnitude of structural fiscal adjustment already in place. Our preliminary calculations suggest an EMU deficit somewhat below 1 percent of GDP in 2006 and 2007. In structural terms, this implies about a neutral fiscal stance in 2006, but an expansionary stance next year when economic growth is expected to gather pace. In light of fiscal requirements in the medium term (discussed in the next paragraph), and with the upturn in train, it would be better in the mission's view to pursue at least a neutral fiscal stance in 2007. This, however, may be difficult at this stage in the political cycle. But any revenue over-performance or, for that matter, below budget expenditure outturns for cyclical reasons, should therefore go to deficit reduction. In any event, the mission welcomes the significant structural fiscal adjustment that will anyway have been achieved during 2004-07, likely close to two percentage points of GDP, and in line with the recommendations of earlier Fund consultations with the Netherlands. Also noteworthy, this will have been achieved while also cutting taxes.
8. Looking further ahead, continued fiscal consolidation and other sustainability-enhancing reforms are essential ingredients of a strategy for securing longer-term fiscal sustainability in the face of aging.
This is well recognized by the authorities and well analyzed in the excellent work of the Bureau for Economic Policy Analysis (CPB). In addition, the mission applauds official efforts to enhance public awareness of aging issues, which hopefully leads to greater political acceptance of the fact that measures must be taken. Perhaps at the risk of oversimplification, the challenge, drawing on the CPB's benchmark analysis, can be expressed in the following way: to achieve fiscal sustainability, either a structural EMU surplus of 3 percent of GDP needs to be achieved by 2011 or shortfalls from this need to be compensated by other measures.
If achieving a fiscal surplus of 1 percent of GDP by 2011 were taken as a starting point, other sustainability-enhancing measures that would reduce the sustainability gap by about 2—2½ percent of GDP (depending on the size of the output gap in 2011) would be required. As noted in the CPB study, examples of the various options to achieve this include increasing the retirement age by 2 years (the mission would support taking into account changes in life expectancy in determining the official retirement age), and abolishing favorable tax treatment for (richer) pensioners. Taken together, these actions, according to CPB calculations, would deliver about 1¼ percent of GDP of the necessary adjustment, still leaving additional measures to be identified, of which further efforts to raise participation could be considered.
While difficult political (and economic) decisions therefore lie ahead, the mission sees some useful guiding principles for formulating a strategy. First, in view of the size of remaining measures even when achieving a fiscal surplus of 1 percent of GDP by 2011, the next government should continue fiscal adjustment. Aiming for a 1 percent surplus or more makes sense: this would represent a significant fiscal adjustment in structural terms and take advantage of the favorable environment provided by the economic upturn. In addition, this seems feasible in light of the Scandinavian experience. Second, to the extent possible, it is better to identify and implement upfront the other measures needed to close the sustainability gap. This reduces the risk of the size of the problem growing and the risk of reducing intergenerational equity, while also adding to confidence that aging is being dealt with. Third, risks are asymmetrical in the sense that the sensitivity analysis in the CPB study ascribes a greater weight to needing a larger structural surplus than 3 percent of GDP by 2011 than to a smaller one. This only accentuates the importance of upfront action. Finally, any budgetary over-performance in 2007 should be saved and used by the next government as an opportunity to pursue more ambitious fiscal targets, thus applying the targeted adjustment it intends to pursue to a better-than-budgeted base.
9. Though some refinements would strengthen the Netherlands' fiscal framework, the IMF's recent report on the observance of standards and codes (ROSC) found that Dutch fiscal practices meet or exceed the good-practice standards. The specifics are spelled out in the publicly available Fund document. Suffice it to say here that roles and responsibilities are, in general, clearly defined; the system of fiscal management is open and well-understood; budget and accounts documents are of a high standard; and the CPB's independent and central role provides a best-practice example of separating the political and technical elements of macroeconomic policy. Proposed refinements pertain to reporting and monitoring of the expenditure ceilings, the inclusion of only certain nontax items in calculating the net expenditure ceiling, the role of the budgetary fund based on gas revenues (FES), tax expenditures, and other recommendations.
Financial Sector Issues
10. The financial sector overall has been performing well. The capital adequacy of banks remains strong. At the same time, other indicators for banks, including measures of return on equity, noninterest expenses to gross income, and nonperforming loans for large banks have been improving. Despite tight interest rate margins on mortgages, reflecting heavy competition between banks for borrowers, continued demand has held up profits—though credit quality has raised some concerns (see paragraph 12 below). With respect to pension funds, the average coverage ratio increased to 132 percent in 2005 (based on market interest rates), helped in particular by a stronger equity market. Earlier stress tests, using 2002 as the base year, had indicated vulnerabilities, with coverage ratios likely to fall below 100 percent in almost all tests. But new tests by De Nederlandsche Bank (DNB), currently underway, are expected to indicate significant improvement. This is because of a stronger base, as well as some reduction in the duration gap. In the insurance sector, earlier stress tests indicated that most shocks, except the most extreme ones, can be absorbed—and, if anything, the situation seems to have improved.
11. Generally strong financial supervision continues to get better. The mission welcomes the new Financial Supervision Act, expected to come into force at the start of 2007, which clarifies and strengthens the framework for financial sector supervision and sets out the requirements that financial services providers must meet.
The Financial Stability Division of the DNB, in addition, contributes to a better overarching view of financial stability issues. Also welcome are the new round of stress tests, coordinated by that division and currently underway, and the efforts to strengthen the risk orientation of supervision, in which greater supervisory resources are devoted to those institutions seen as having higher risk profiles. Meanwhile, initial teething pains from the supervisory work of the DNB and the Authority for Financial Markets (AFM) appear to have been resolved, with the roles of the two institutions now better defined and understood. The failure of one small bank has provided an opportunity for learning from a real-world experience and an example in broad outline of the system working: the bank's emerging problems came as no surprise to supervisors; supervisors closed the bank by enacting emergency regulations; and the event added a degree of market discipline by demonstrating, fortunately without systematic repercussions, that a bank can fail.
Within the framework for pension supervision, one key aspect is still under discussion—namely, the appropriate recovery period when a pension fund's coverage ratio falls below 105 percent. The time period specified should ensure that corrective actions by a pension fund are not unduly postponed. It should also, because of the threat of intervention, ensure discipline. In this context, it is important to note that pension funds are not subject to the same market discipline as banks in the sense that individuals have no choice on the pension fund to which they contribute. Absent this market discipline, and in light of the increasing complexity of financial markets and instruments, there is an even more compelling case for strong supervision. Taking these considerations together, the mission can therefore support the ex ante specification of a one-year recovery period, but would also emphasize that flexibility is absolutely indispensable. Thus, there clearly needs to be appropriate escape clauses to allow a longer recovery period, as planned. The DNB has already demonstrated flexibility with longer recovery periods, which may be needed, for example, if macroeconomic distress or systemic pension problems were to arise, and, more generally, when well-formulated recovery plans, backed by sound management, call for a longer period to avoid unnecessarily penalizing pension holders.
12. Financial vulnerabilities have nevertheless arisen that could adversely affect the economy even though there is no particular threat to financial stability overall.
Although some mitigating measures have been implemented, the tax deductibility of mortgage interest payments and innovations in mortgage financing (like interest-only mortgages and low initial interest rates on flexible rate mortgages) have strongly encouraged a rapid run-up of debt. This is particularly evident when put in an international context, with mortgage debt having shown particularly rapid growth in the Netherlands and the ratio of mortgage debt to GDP at a particularly high level well over 100 percent. At the same time, the proportion of mortgages subject to an interest rate adjustment within two years has increased (from 21 percent in 2004 to 31 percent in 2005, according to DNB figures), and the percentage of newly provided loans with loan-to-value ratios exceeding 100 percent has been increasing significantly.
While the debts taken on by borrowers necessarily have assets as their counterparts, house prices do appear to be sensitive to interest rates. Thus, borrowers—especially newcomers to the market without financial buffers—could be hurt significantly should interest rates substantially rise, both through a fall in asset values and higher interest rates on their mortgages. We therefore welcome the review and strengthening of the code of conduct for mortgage lending in response to the worries voiced by financial supervision. But to be effective, it will be essential that compliance with the new code be monitored carefully, with appropriate actions taken if violations were to occur. It is not yet clear that this will happen, a situation that needs to be rectified. From a longer-term perspective, the mission supports ongoing research efforts to find a way to phase out the tax deduction for mortgage interest payments while minimizing disruptive effects. There are advantages for the budget, including by providing room for tax cuts which could also lessen the downward impact on demand and stimulate labor participation. More generally, it would be worthwhile to study whether other possible improvements could be made to the functioning of the housing market, including by examining whether rent controls and administrative allocation mechanisms appropriately serve their intended social and economic purposes.
13. Continuity planning is essential to minimizing financial system disruptions if an avian flu pandemic were to occur. The mission therefore welcomes the way Dutch officials have handled the subject: the appropriate issues have been well publicized by the authorities and put on the public's radar screen, including by having all supervisors ask financial institutions how they are preparing. The Dutch authorities, more generally, are seen as being at the forefront of dealing with financial issues related to a possible pandemic.
14. Several, not always easy, measures have been taken to raise labor participation. These enhance potential growth and the soundness of the public finances, and reduce the moral hazard associated with social insurance. Earlier reforms of the disability scheme had already reduced inflows significantly, and reassessments of the existing stock have resulted in reclassifications. The more recent reform distinguishes between partly and fully disabled and, in doing so, enhances the incentives to participate in the labor market for those who can. In addition, other reforms now make early retirement actuarially fair. Still, the operations of the "life-course scheme" are not yet fully clear, and it would be unfortunate if it effectively became a vehicle solely for subsidizing early retirement. The reduction in the duration of unemployment benefits to three years, and reduction in inactivity and poverty traps (following the abolition of the real estate tax and smoothing of the income dependency of the child credit) should further induce higher participation. In all, the mission welcomes changes in labor market policies that better align work effort and the return from work. It also welcomes policies that aim to minimize the negative effects on labor participation and effort in trying to satisfy society's preferences for equity.
15. Looking ahead, some further measures should therefore be considered, drawing on the CPB's excellent study on welfare state reform. Smoothing the income dependency of the rent subsidy would reduce other spikes in marginal tax rates (and could be designed in a way to lessen the budgetary impact). Moreover, room exists, in the mission's view, to further reduce the duration of unemployment benefits, which still is generous by international standards, and introduce a more rapid decline in replacement rates during the duration of the benefits. Further measures to lower the cost of childcare and individualize the tax credit for non-participating partners are also promising avenues to increase participation. A reduction in the minimum wage can be effective in increasing low-skilled employment, and would be more acceptable in the context of equity considerations if the negative effects on equity were mitigated through an earned tax credit. Relaxing the role of seniority in determining wages could also increase participation and mobility for senior workers.
16. Structural reforms to raise productivity growth are a necessary complement for boosting the economy's growth potential and would also help raise the standard of living while dealing with population aging. It appears, however, that overall productivity growth has been slowing some when purged from cyclical influences. Thus, the mission supports efforts to increase competition, for example by unbundling of the energy market and through the important work of the competition authority. Indeed, product market reforms can also facilitate labor market reforms, notably by dampening the impact of the latter on real wages. In addition, the mission welcomes the success in reducing red tape (the goal of a 25 percent reduction should be achieved before the end of the government's term), including by reducing the number of permits and license systems which can adversely affect innovation and experimentation. It also encourages, as in the past, greater wage differentiation (to attract labor to higher productivity companies and sectors, while strengthening the incentives for human capital investment), and less strict employment protection legislation (which basically acts as a tax on new hiring and labor reallocation and can therefore also hamper innovation). While employment protection may not in practice be as strict as implied by available indices, there still appears to be room for greater flexibility and, at a minimum, it is worth investigating whether procedural costs can be reduced further. It is also important to ensure that sufficient space is left within the budgetary envelope for education, infrastructure, and market-oriented incentives for R&D.
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In all, what has been accomplished is impressive. While challenges lie ahead, the Netherlands, if recent history is a guide, is up to the task. As always, the mission is truly grateful to the authorities and other participants for the frank, high quality, and stimulating discussions.