Mission Concluding Statement 

June 14, 2011

With the economic recovery well under way, policies should be stepped up to address both new and long-standing challenges. Government deficit and debt levels, much deteriorated in the last few years, must return to safer grounds. This requires more fiscal measures, but can be achieved while making the government more effective and fostering long-term growth. The financial sector is healing after the severe shocks of 2008–09, but this rebound does not make the lessons from the crisis less relevant.

More specifically, we encourage the authorities to:

• Adopt a more ambitious fiscal consolidation plan starting with the 2012 budget. This plan should create incentives for older workers to retire later, improve efficiency in the health care sector, and rationalize subsidies.

• Gather momentum toward a comprehensive fiscal federalism reform to better align spending and financing responsibilities.

• Press banks to further build up high quality capital and exit government support; enhance bank supervision and macroprudential regulation, in coordination with ongoing international efforts.

• Increase long-term growth prospects by improving labor utilization of low-skilled workers and fostering human capital accumulation through education reform.

I. Macroeconomic Outlook And Challenges

1. The economic recovery is well under way, owing to the prompt policy response to the crisis and a favorable external macroeconomic environment. Unemployment and capacity utilization are back to normal. GDP growth has been stronger than expected and is likely to reach around 3 percent this year, before returning to more normal levels as the cyclical recovery runs its course. Commodity price shocks, higher indirect taxes, and the strong economy have pushed inflation above the euro area average. The external accounts are healthy and there are no concerns about international competitiveness. Large banks are returning to more normal levels of profitability, while more challenges remain for a few other banks, where intense restructuring is taking place.

2. The risks to this positive outlook are mostly to the downside, and arise notably from the fragile situation in part of the euro area periphery. Although Austrian banks have comparatively little direct exposure to the periphery, renewed generalized stress in European financial markets would likely affect both the banking sector and the real economy. A broad economic downturn in the euro area could also spill over to Central, Eastern, and South Eastern Europe (CESEE) and put additional pressure on the quality of Austrian banks’ assets in the region.

3. The crisis, though short-lived in Austria, has highlighted old challenges and created new ones that must now be addressed through forceful policy measures. Crisis management required sizable government resources to support aggregate demand and the financial sector. While Austria’s fiscal position compares favorably with other euro area countries, the growth of debt needs to be put into reverse to re-create fiscal space and to better face the upcoming costs of an aging population and other fiscal pressures. Regarding the financial sector, as the CESEE convergence process resumes, bank expansion needs to be more prudent than before the crisis. Also, low profitability and excess capacity in the Austrian banking market are long-standing problems. Finally, policies are needed to support higher economic growth in the medium-term, which would also help the fiscal position. Here the challenges are to improve the utilization of low-skilled and older workers and build up human capital.

II. Fiscal Policy

4. The economic recovery and the measures adopted with the 2011 budget are helping the fiscal balance, but debt remains well above pre-crisis levels and a number of risks weigh on the fiscal accounts. Better-than-expected GDP growth and the multi-year consolidation plan of October 2010 will reduce the deficit significantly—to around 2 percent in the medium term. However, debt will remain above 70 percent of GDP by 2015 and the pace of decline will be slow. Furthermore, there are additional liabilities in public enterprises, population aging will accelerate after the end of the decade, cost pressures in the health care sector are strong, and the large banking sector remains a potential risk to the public accounts.

5. To put the public finances on more solid ground, we urge the authorities to take additional consolidation measures starting with the 2012 budget. Total measures should amount to at least 0.5 percent of GDP per year, until the fiscal accounts are structurally balanced. This would bring the debt-to-GDP ratio on a clear downward trajectory in the medium term. A stronger consolidation effort in the 2012 budget is warranted in light of the excellent economic performance and rapidly disappearing slack in the economy. It may also help contain inflationary pressures should they prove more durable than expected. Measures should focus on long-lasting structural expenditure reforms and be implemented without overly lengthy transition periods.

6. Priority should be given to pension, health care, and subsidy reform—areas with considerable scope for rationalization. Although the authorities have taken some useful steps in all three areas, there remains considerable scope to redesign government intervention and make it more efficient and supportive of long-term growth.

7. Widespread early retirement is no longer affordable as the population becomes older. The average effective retirement age in Austria is one of the lowest in the OECD. Early retirement was used in the past to avoid layoffs as the economy was undergoing structural changes. Today, with low unemployment and an aging population, shortage of labor is a bigger source of concern. While some useful measures have been put in place, lasting change requires action on several fronts: avenues to inactivity for older workers without fair pension reduction need to close across-the-board or else outflows will move from closed programs to still open ones. In parallel, job opportunities for older workers need to be improved. Cooperation with social partners is required to make progress on this long-standing issue. With aging accelerating after 2020, and taking implementation lags into account, time is running out.

8. Expenditure rationalization is possible in health care. The Austrian health care system is of a high standard, but costs are mounting quickly because of population aging and technological advances in medical care. Reconfiguring the size, specialization, and geographical distribution of hospitals would realize economies of scale and a better allocation of resources; in parallel, outpatient treatment and prevention could be reinforced. Reforming health care financing is necessary to create the incentives to achieve these goals.

9. The extensive system of subsidies to both public enterprises and the private sector should also be reformed. It should be made more transparent, subjected to rigorous cost-benefit analysis, and targeted better. The initiative by the government to build a transparency database on subsidies is a welcome first step.

10. A broad reform of fiscal federalism would yield considerable efficiency gains. In the above and many other areas (such as education), a strong disconnect between spending and financing responsibilities among different levels of government is pervasive and distorts incentives for an efficient use of public resources. A comprehensive fiscal federalism reform would address these problems and should be agreed upon before the next negotiations on the fiscal equalization law. With preparatory work already far along, this goal should be achievable.

III. Financial Sector Policies

11. The banking sector’s return to more normal levels of profitability creates the conditions for the further build-up of high-quality capital and the exit from government support. In Austria, bank assets are performing well even though the strong appreciation of the Swiss franc is increasing the burden of mortgage debt denominated in that currency. In the CESEE countries, the recovery is faster than expected, and banks’ provisioning against loan losses is slowing down. However, the high stock of foreign currency loans remains a source of vulnerability. As banks return to profitability, they should give priority to further building up high-quality capital to reach the new Basel III standards (as reflected in the forthcoming EU directive) and exiting government support. This should take priority over shareholder remuneration and further cross-border expansion. The ongoing restructuring of some banks is an opportunity to address overcapacity and low intermediation margins in the Austrian market.

12. Supervisors have stepped up monitoring of macro-financial risks, but need to be ready to take early and decisive actions to prevent the re-emergence of imbalances. Greater vigilance of lending activities is necessary wherever financial deepening can quickly turn into an unsustainable credit boom. Vigilance should be accompanied by pre-emptive action, in coordination with host country supervisors if warranted. In this respect, we welcome the establishment of a cross-border financial stability group with authorities from most new EU member states where Austrian banks operate. Austria’s early leadership in international initiatives to make foreign currency lending in CESEE more selective is also commendable.

13. During the transition to robust EU-level bank resolution mechanisms, including for cross-border institutions, national measures need to be taken to address the risk posed by systemic banks. The crisis has highlighted that some banks are “too systemic to fail” and that there aren’t yet well-defined mechanisms to share the burden of rescuing these banks among the countries where they operate—including within the EU. With a large, internationally active banking sector, Austria has much to benefit from the current EU initiative to build such mechanisms. Until a new framework is in place, the risk that systemic banks pose to Austrian taxpayers should be reduced through tighter capital requirements and, possibly, constraints on their intra-group funding models.

IV. Structural Issues

14. Higher labor market participation of low-skill workers would increase long-term growth. Although overall unemployment is small and labor force participation has increased, employment rates among low-skill workers are modest in international comparison, likely reflecting high social security contributions that increase the cost of labor. More progress in reducing these “tax wedges” would be welcome.

15. Growth prospects can also be improved by policies that raise educational attainment. A priority is to close the large attainment gap of children with an immigrant background, some 20 percent of primary school pupils, to ensure that these children have good labor market prospects. Furthermore, for a high-income country like Austria, continued economic growth requires moving up with the technology frontier. The authorities are aware of this and provide generous support to R&D activities; however, policies to foster human capital, a necessary input to R&D activities, should receive more attention. The university system is burdened by low graduation rates and has low enrollment in engineering and the natural sciences. Stricter admission criteria to limit enrollment would increase the proportion of students who graduate, make better use of existing resources, and could be used to steer students toward disciplines more relevant for R&D.

16. The mission wishes to thank the authorities and all other counterparts for their cooperation and hospitality.