Kingdom of the Netherlands -- The Netherlands, 2008 Article IV Consultation: Preliminary Conclusions
March 17, 2008
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.
Strong macroeconomic foundations have so far shielded the Netherlands from financial turbulence, but important challenges lie ahead. Following the prolonged stagnation early in the decade, a solid recovery has taken root. Growth is among the highest and inflation the lowest in the EU, various measures suggest that competitiveness is adequate, and the fiscal position is in surplus. Expansion is set to continue, but uncertainties associated with the financial markets turmoil are high. Looking forward, lagging productivity trends, rapid population aging, and relatively low labor utilization could significantly slow long-term growth and impair competitiveness and fiscal sustainability. Complex products, pressures on profitability, and growing financial integration create new risks and supervisory challenges. To alleviate these concerns, the mission encourages the authorities to reform public spending programs as well as labor and product markets. It also counsels enhancements in financial sector supervision, including increased international cooperation.
1. Financial jitters have not dented macroeconomic performance so far. GDP growth in 2007 at 3½ percent is the highest since 2000 and among the best in the euro area. It was led by strong expansion of exports, especially re-exports, and investment, with a more moderate contribution from private consumption. Harmonized inflation at 2 percent (year-on-year) in February 2008 stays subdued, well below the EU average. Labor market developments are also positive, but point to tightening conditions, with a falling unemployment rate and vacancies sharply increasing. Strong export growth, as well as various other indicators, suggest adequate external competitiveness.
2. Fiscal performance remained strong in 2007, albeit mildly pro-cyclical. After improving by almost 4 percent of GDP over 2003-06, the overall balance of the general government was unchanged last year, with a moderate surplus, but in cyclically-adjusted terms it slipped by about ½ percent of GDP. This reflected the absence of an expenditure ceiling during the government interregnum and discretionary decisions. Nevertheless, the government debt ratio continued on a declining path, comfortably below the Maastricht limit.
3. Long-term fiscal sustainability is still elusive owing to population aging and attendant budgetary costs. The Netherlands is in a relatively favorable position to deal with this problem. The initial fiscal position and demographics are comparatively benign. In addition, the existence of a large, fully funded, second pension pillar helps mitigate the brunt of aging. However, the fiscal impact is large (7 percent of GDP in additional expenditures by 2040, mostly on account of healthcare and pension costs). If not offset by a reduction of aging-related entitlements and other spending or revenue increases, this burden would lead to an unsustainable deterioration in public finances.
4. The financial system appears generally robust and well supervised. In 2007, corporate loans rose rapidly, while mortgage growth fell sharply, reflecting higher interest rates and possibly tighter credit standards under the new Code of Conduct. Risk-weighted capital ratios are comfortable, though Tier 1 capital is comparatively low. Dutch banks report limited direct and indirect exposure to subprime loans, but with related losses and write-offs reaching about €7.5 billion for 2007, overall profits fell significantly. Pension funds' average cover ratio was solid at 144 percent at end-2007, but has dipped significantly since, reflecting lower stock prices and interest rates. Results for 2007 among insurers were mixed. Stress testing by the central bank (DNB) suggests that Dutch banks can withstand fairly adverse shocks, albeit the funding ratio of pension funds would suffer more. The Dutch supervisory framework and operation follow best international practice.
5. Nevertheless, a few pockets of softness and the uncertain impact of the global turmoil warrant caution.
• In the short run, the full consequences of the distress in world financial markets are still unclear. For internationally active banks, losses from subprime loans and other asset classes could rise. Pension funds could suffer further losses in equity markets and stagnating life insurance premia are a concern. In general, risks relating to liquidity, valuation, and recapitalization—although manageable—have increased under disturbed market conditions. While a full-blown credit crunch is unlikely in Europe, the latest ECB survey points to a tightening of lending conditions.
• In the longer run, sluggish productivity and comparatively lackluster profitability (though risk-adjusted profitability may fare better) in the Dutch financial sector weigh down on its ability to support growth and adaptation of the economy. Also—as underlined by the recent turmoil—complex products, deepening international integration, high mortgage debt and rising securitization test internal risk management and supervision of financial institutions.
Outlook and risks
6. Economic expansion, albeit slowing, is set to continue. Thanks also to the strong momentum at end-2007, the mission expects growth to remain above the euro area average in 2008, but to brake to just about 2¼ percent. Both consumption and investment are projected to decelerate, but with the foreign contribution to growth dropping the most. Inflation is anticipated to rise moderately, with the output level remaining above potential and wages expected to rise more than productivity amid a tightening labor market. Over the medium-term, after a further slowdown in 2009 to 1.8 percent owing to the lingering effects of the financial turmoil, GDP should expand in line with potential output (about 2 percent).
7. Uncertainties regarding the outlook are high, but risks broadly balanced. Main risks include shifts compared to the baseline in: (i) lending conditions, owing to global financial market developments; (ii) housing and equity prices, that could sway domestic demand given strong links in the Netherlands between private consumption and housing or stock market trends; (iii) oil prices; and (iv) external demand. The mission believes that upside and downside outcomes for these risk factors are equally probable, but their dispersion is pronounced, because of the uncertainty on the extent of the global financial crisis and its impact on consumer and producer confidence, both quite volatile.
8. Looking further ahead, the challenges of an aging population, with comparatively low productivity growth and labor utilization, loom large. Productivity growth in the Netherlands, despite some recent recovery, remains slower than in partner economies. Further, imminent population aging will shrink the working-age cohorts from early the next decade. Thus, in the mission's view, raising the employment rate and stimulating faster productivity grains throughout the economy will be key for long-term potential growth and competitiveness prospects—and will also aid fiscal sustainability.
9. Accordingly, the recommendations of the mission focus on fiscal policy, structural reform, and financial sector issues. Specifically on: (i) tax and public expenditure measures that support economic expansion while ensuring fiscal sustainability; (ii) reforming the labor and product markets to enhance utilization of human resources and competition; and (iii) maintaining stability and raising efficiency of the financial sector.
10. Though the budget position is already strong, a somewhat tighter fiscal stance in 2008 and 2009 would be appropriate. Multi-year expenditure ceilings have served budgetary discipline well and thus surpluses of some ½ percent of GDP are planned for both years. However, when adjusted for cyclical conditions, gas proceeds, and net interest payments, the underlying balance would weaken appreciably with respect to 2007. With output above potential, a modest withdrawal of fiscal stimulus may instead be advisable. (Conversely, were growth to fall significantly short of current estimates, automatic fiscal stabilizers should be allowed to operate fully).
11. Thus, the mission advises to err on the side of higher surpluses in executing fiscal policy. Projections point to a sizable revenue overperformance, owing mainly to cyclical upswing and buoyant gas proceeds. Also, potential savings are associated with underexecution of investment projects financed by the Infrastructure Development Fund and other margins under the expenditure ceilings. From both cyclical and long-term sustainability perspectives (see below), the mission favors realizing these potential savings. Should this not prove feasible, the additional spending ought to support structural reforms that will over the medium run help achieve fiscal sustainability. In this context, the mission also cautions against the risk of slippages in controlling expenditures on health- and child-care services.
12. The government's medium-term surplus target is welcome, but further action is needed to ensure long-term sustainability. The mission broadly endorses the 1 percent of GDP structural surplus targeted for 2011 and the government's important sustainability-enhancing measures. Nonetheless, fiscal sustainability requires further adjustment totaling about 2¼ percent of GDP. In the mission's view, given the better-than-budgeted outcome for 2007 and likely overperformance in 2008-09, the structural surplus could be ½-1 percent of GDP higher in 2011 (adjusted for deviations in gas revenues from the multiannual budget). The mission would support this stronger outcome. Indeed, frontloading the fiscal correction contains the size of the required tightening, and is desirable for intergenerational equity.
13. Adjustment should focus on expenditure retrenchment or tax base broadening. The government's economic footprint is sizable, and set to increase further with aging-related expenditures. Lifetime marginal income tax burdens are quite high for a substantial part of the population, and comparatively large tax wedges on earned income discourage work. Moreover, international tax competition may lead to more cuts of corporate tax rates.
14. Savings are possible in the retirement system, health care, unemployment-benefit and some other expenditures. Further pension reform is key to contain the fiscal costs of aging. With life expectancy having risen markedly in recent decades, consideration should be given to increase the retirement age, as in some other EU economies. Given the sensitivity of this proposal, the increase could be phased so that workers near retirement would be little affected. Additional efforts to rein in health care expenditures will also be required, as overruns are already apparent. The mission sees scope to reduce unemployment-benefit duration which remains high by international standards. This would raise labor participation while continuing to support job search. Finally, some international comparisons suggest that public expenditure efficiency could be further enhanced—building on existing efforts—especially in public administration, education, and infrastructural investment.
15. The Dutch budgetary system deserves high marks, but further refinements would reduce procyclicality, facilitating long-term sustainability. The mission welcomes the governments' recent improvements to the fiscal framework, like the exclusion of interest payments from expenditure ceilings, which has already alleviated procyclicality. However, there are some procyclical elements left. Specifically, tax deductibility of mortgage interest and pension contributions to the second pillar are both procyclical, as house prices and household income tend to rise with GDP. The mission favors increasing the role of automatic stabilizers. With this aim, it proposes that all tax expenditures—including mortgage interest deductibility and the tax exemption on pension payments—be reported in the budget and, if feasible, included in the expenditure ceilings, while unemployment benefits be excluded.
16. Efforts to increase employment would ease growing labor shortages, support growth, and alleviate the effects of population aging. Despite relatively high employment rates and recent reforms, hours worked per employee are the lowest in the OECD. Thus, the mission supports reforms of the tax system, social entitlements, and employment protection.
• Further reduction in the still high effective tax rate on second family workers and faster elimination of the imputation of the general tax credit to the primary worker would encourage female employment. To stimulate elderly participation, the mission supports targeted increases of income tax credits for workers aged 57 and above and exempting pensioners that have worked between ages 63-65 from the new levy for the over 65.
• With the share of working-age population receiving social entitlements comparatively high, access to the young disabled scheme should be tightened. In addition, the mission counsels stricter enforcement of work availability requirements and extension of the new stringent rules for periodic reassessment of disability status to those aged 45 and over. As for the unemployment scheme, besides firmer work availability requirements, benefit length could be restricted—as noted above—or benefits further diminished over the unemployment spell to intensify job search activity.
• Strict employment protection legislation (EPL) for regular employment results in high long-term unemployment and may hinder labor mobility or process innovation. In addition, severance payments are relatively generous and may also reduce labor mobility to prevent loss of accumulated severance rights. To alleviate these concerns, the mission advocates relaxation of EPL and a funded severance pay scheme.
17. Recent actions to boost competition and innovation are welcome, although further liberalization is needed to promote productivity growth. The authorities "innovation pillar" should facilitate the adoption of new technologies. The recent strengthening of the competition authority's (NMa) investigative powers should kindle competition and thus productivity. The mission also welcomes the government's intention to reduce red tape by an additional 25 percent. However, according to international ranks, barriers to entrepreneurship are still relatively high. Importantly, despite recent progress, zoning regulations remain rigid, which, combined with strict shop opening and delivery hours, hampers the emergence of larger retail establishments that could better exploit information and communications technologies. The mission recommends greater liberalization, while recognizing the downsides of too much a shift to "big box" retailing.
18. Improved transparency is key to financial sector stability. The bout of capital market distress underscores the need to strengthen disclosure and prudential regulation of complex products. The mission recognizes the authorities' contribution to the international dialogue in this area and urges a concerted effort by EU supervisors toward better disclosure of such instruments (on balance sheet, contingent, or with affiliated entities) and related credit or liquidity lines. Where necessary, institutions should be encouraged to bolster their capital proactively. Early problem identification relies also on stress testing by the DNB—of excellent quality and administered with state-of-the-art models. Nevertheless, it needs to continue adapting to novel risks (including difficulties in raising capital and liquidity), rapid rating migration, more adverse asset valuations, and incorporate the insurance sector fully.
19. Takeover of a large Dutch bank by an international consortium typifies rising supervisory challenges. It underlines the difficulties of supervising large EU-wide financial institutions by national regulators and the burden of complying with multiple regulations. The mission welcomes the decision to maintain the DNB as principal supervisor until full completion of the takeover. Further, noting that cross-border cooperation by supervisors is excellent, it stresses the importance of reviewing existing memoranda of understanding and clarifying fiscal responsibility for crisis management and lending of last resort functions.
20. The Dutch mortgage market is relatively efficient but volatile house prices, high mortgage debt, and securitization require watching. Although less overvalued than in some other advanced economies, house prices have risen sizably over the past decade. Mortgage interest deductibility fuels these increases, reduces affordability, and discourages amortizing loans, exacerbating households' vulnerability to price swings and interest rate shocks. Therefore, the mission reiterates past advice to limit mortgage interest deductibility, removing rent controls, and easing zoning restrictions to stimulate housing supply. While non-amortizing mortgages typically carry separate collateral, regulatory action to reduce high loan-to-value ratios, better measurement of related collateral, and fine-tuning capital requirements for mortgages with different risks would be useful. Finally, rapidly growing securitization warrants increased vigilance about the adequacy of origination standards and improved assessment of rating models, as well as capital and liquidity requirements that appropriately reflect the risks of buyback or liquidity extension to conduits.
21. The mission welcomes that the Netherlands' ODA contributions at 0.8 percent of GDP continue to exceed the United Nations ODA target.
22. The mission is grateful for the high quality and openness of the discussions, and the cooperation and hospitality received from the Dutch authorities and private sector.