Mission Concluding Statement 

Brussels, January 27, 2012

Amidst uncertainty about the evolution of the financial crisis and the depth of the recession in Europe, the Belgian economy faces a difficult outlook. An effective and comprehensive policy response both at the European and the national level is called for. The new federal government’s determination to restore sound public finances, contain risks in the financial sector, and increase the employment rate is encouraging. In light of financial markets’ concerns about the euro area, the full implementation of the government’s program is crucial and the authorities should stand ready to take further action when needed.

Uncertainty about the depth of the recession

The Belgian economy remains highly vulnerable to turmoil in the euro area in light of its openness, the high public debt, and substantial international linkages of the financial sector. The risk of negative feedback loops between the sovereign and financial sector endures. Sovereign and bank yield spreads may remain under pressure for some time to come. Downside risks to the outlook are significant, although high household wealth may provide a buffer to the transmission of foreign shocks to domestic sovereign stress.

In this environment and with fiscal tightening across Europe, the economic outlook is challenging. A recession in Belgium is already underway and real GDP is expected to stagnate in 2012, followed by a slow recovery in 2013. As economic activity stalls, and labor market reforms take time to have effect, the unemployment rate would rise again. The relatively high inflation in 2010-11, mostly due to energy price hikes, is being partly propagated by the automatic wage indexation. Despite increasing slack in the economy, significant nominal wage increases would keep inflation above 2 percent in 2012, put pressure on the budget, and weaken competitiveness.

The new government’s program

The new federal government has begun to address long-standing problems in the Belgian economy. The government program appropriately aims at achieving a structurally balanced budget by 2015 as well as raising the low employment rate by 5 percent by 2020, and contains an agreement to increase fiscal decentralization from 2014. The near-term measures are important first steps towards achieving these objectives. In particular, the program includes a sizable fiscal consolidation package, and wide-ranging labor market and pension reforms.

The government program is off to a good start and continued persistence in its full implementation is crucial. Over the medium term, further action is needed to deal with rising aging costs while reducing the high public debt, and to bring the low effective retirement age close to the legal retirement age of 65 years. Sustained job creation and boosting growth are indispensable for sound public finances and require pushing ahead with reforms in labor and product/services markets. A job-friendly tax reform could increase trend growth.

Credible medium-term fiscal consolidation

Resuming credible fiscal consolidation remains a priority, in order to bring down the high public debt over the longer term. In light of the vulnerability of Belgium’s sovereign debt to market pressures, it is essential to reduce the deficit in 2012 to the Stability Program’s target of below 3 percent of GDP. The draft 2012 budget, together with a partial spending freeze, contains sizeable fiscal savings measures. It is important that the ad hoc spending freeze is replaced at the time of the February budget review by structural measures of sufficient magnitude to enable reaching the deficit target. In this connection, the costly automatic wage and benefit indexation should be reconsidered against other spending priorities, while taking into account its potential impact on competitiveness and growth. All levels of government will need to undertake determined and well-coordinated savings measures. Should growth fall significantly below current projections, the automatic stabilizers should be allowed to operate to buffer the downturn as long as government market access is not jeopardized.

After 2012, a considerable additional consolidation effort will be required to achieve structural balance by 2015. With government revenues already close to 50 percent of GDP, measures should mainly focus on the expenditure side, especially continued pension reforms that would further raise the effective retirement age; measures to keep the real growth rate of health care spending at 2 percent; and curtailing public sector employment by not replacing a sizable share of the public employees who will retire over the coming years at all government levels. In light of the weak growth prospects, the automatic stabilizers should be allowed to operate freely around the consolidation path.

The fiscal consolidation effort should be set in a strengthened institutional framework. In particular, consolidation should be based on a renewed burden-sharing agreement between all levels of government and be set into a rules-based framework for the general government, including spending caps at each level of government. A structural fiscal rule, in line with the EU Directive on Requirements for Budgetary Frameworks, would add credibility to the consolidation effort. The rule should include a provision that unforeseen additional revenues be assigned to public debt reduction. A multi-year perspective, based on realistic revenue assumptions and an in-depth expenditure review, would help prioritize spending programs. Such a rule-based, multi-year framework for the general government will become increasingly important as the sixth state reform takes effect in 2014 and the degree of fiscal federalism widens. Close coordination between the regions and municipalities should ensure adherence to a fiscal deficit path that is consistent with the fiscal targets committed to at the European level.

Safeguarding financial sector stability

Important steps were taken to address the renewed financial sector distress in 2011, but the authorities should remain at full alert to risks. Significant financing strains for the Dexia Group set in motion a renewed intervention by the authorities in Belgium, France, and Luxembourg. These actions proved so far stabilizing, albeit at the cost of a significant rise in the state’s contingent fiscal liabilities. Going forward, the execution of the Dexia restructuring plan will require continued vigilance, intensive supervisory and government oversight, and coordination among all relevant authorities to prevent contagion and minimize future fiscal costs.

Banks should continue to build up capital to deal with possible adverse market dynamics and maintain funding access. Considerable deleveraging since the beginning of the crisis, especially in banks’ cross-border operations and non-core activities, has contributed to stronger capital ratios. At the same time, the Belgian financial system remains exposed to countries with weak growth prospects, fragile sovereign debt markets, and stressed financial markets. The authorities should take steps to ensure that banks have strong capital buffers, in line with forthcoming Basel III capital requirements, that are achieved as far as possible by increasing capital rather than slowing down credit. Reinforced capital buffers, if needed to be provided by the state, are essential to enhance confidence in the banks and to cope with risks stemming from potentially worsening market conditions.

The efforts to strengthen prudential supervision and develop the macro-prudential toolkit need to be pursued. The integration of the prudential supervision over banks and insurance companies into the central bank is progressing and the new Financial Services and Markets Authority has been launched. The central bank should continue with the challenging task of organizing the supervisory function in a manner that enables to reap synergies with the traditional roles of the central bank. It is important to expeditiously implement the authorities’ plans to further strengthen resources devoted to prudential supervision, in order to ensure intensive supervision, monitoring of cross-border exposures and close co-operation with foreign supervisors. The dialogue with foreign supervisors should be aimed at acquiring a thorough understanding of international groups’ activities, their governance, and the risks involved to enable a more intrusive oversight and timely corrective action. Limiting intra-group exposures of Belgian banks from end-2012 and adopting proposed covered bonds legislation would enable banks to shore up liquidity and tap new sources of wholesale funding at critical moments.

Strong financial safety nets are important in the current environment of elevated market volatility and uncertainty. The introduction of risk-based contributions to the deposit guarantee system and the setting up of a financial stability fund are welcome. Going forward, the authorities should ensure that the newly designed deposit guarantee scheme has adequate resources, a sufficient degree of autonomy and strong governance arrangements in line with best international practice, while taking account of potential synergies with other resolution mechanisms. To facilitate effective policy actions, it is important to formalize the exchange of information and to maintain close cooperation on financial stability issues among the relevant national authorities.

Kick-starting structural reforms

Trend growth has fallen from almost 2 percent in the mid 2000’s to about 1 percent in recent years, reflecting both demographic factors and the impact of the financial crisis. While trend growth is expected to recover gradually to a rate of 1½ percent by 2016, strong efforts to step up employment and productivity growth would be needed to boost growth over the medium term.

The government program contains labor market and pension reforms that are important first steps towards raising the employment rate. The measures include greater degressivity of unemployment benefits, tightened job search requirements for the unemployed, and a higher minimum age for various early retirement benefits. The reforms appropriately strengthen incentives for younger workers to enter and for older workers to remain in the labor market. Nevertheless, further steps may be needed to achieve the government’s employment goals. A national dialogue should be initiated to prepare for continuation of the pension reform to lift the effective retirement age close to the official retirement age, including by introducing actuarially neutral discounts on early retirement benefits. This should be complemented by a compact between the social partners that would develop suitable employment opportunities for older workers. Unemployment benefits could be means-tested or phased out after a fixed period, thus further encouraging intensified job search efforts. To help the unemployed more effectively to find a job, resources could be shifted from employment subsidies and incentives towards enhanced search assistance and training, especially in regions with high unemployment.

A comprehensive tax reform could boost employment and growth, and help restore fiscal sustainability. Belgium has the highest labor taxation in the OECD, which significantly discourages employment and growth, and raises the cost of the social benefit system. Given the lack of fiscal space, any reduction in labor taxes would have to be offset by an increase in tax revenues that are less detrimental to more labor-intensive growth. A significant reduction in employers’ social security contributions could be financed by broadening the tax base of the value-added and personal income taxes, and by bringing environmental and property taxation in line with the higher levels in neighboring countries. This could bring tangible employment and growth gains.

The automatic wage indexation mechanism should be reconsidered. The scope should be increased for tailor-made sectoral wage negotiations. This would limit pressure on the budget and reduce incentives to downsize staffing in sectors that are particularly hard-hit by the recession. A reform should at least aim to avoid second-round effects of energy price hikes and potential increases in indirect taxation, thereby preventing a further deterioration of Belgium’s wage cost competitiveness.

Competition policy should be strengthened further. In the energy sector, barriers to entry could be further reduced and regulatory oversight should be strengthened. The EU Services Directive has been transposed into national legislation but further steps are needed to achieve its full implementation.

In conclusion, the IMF mission team would like to thank the authorities for their generous hospitality and the open and constructive discussions.