Mission Concluding Statement 

January 28, 2008

A weaker external environment and continuing global financial turbulence are dampening economic prospects. Despite the spike in inflation, purchasing power is expected to hold up relatively well, partly owing to partial indexation practices. Going forward, wage restraint will be needed to preserve competitiveness. More worrisome is the recent hiatus in policy making at the federal level, especially as the window to deal with population aging is closing rapidly. It will be essential to return fiscal consolidation to an ambitious track, starting with a small budget surplus in 2008, ensure that reforms of fiscal federalism arrangements address existing imbalances without fiscal costs, and press ahead with structural reforms to strengthen growth. Meanwhile, the impact of the financial turbulence on the financial sector appears manageable, while better disclosure of exposures would help ease tensions.

I. Outlook: Dealing with Slower Growth and an Inflation Spike

Following the recent robust expansion, economic growth is expected to slow, amid considerable uncertainty. Weaker global activity, protracted financial turbulence, higher energy and food prices, and euro appreciation are together providing a strong headwind for the economy. As a result, economic growth is likely to fall to 1.6 percent in 2008, in line with the expected decline in growth in the euro area. The interruption in economic policy making owing to the difficulties in forming a new federal government after the June 2007 election has added uncertainty at a difficult time. While past sound economic policies will continue to support the economy, it will nonetheless be important that the new government swiftly adopt a 2008 budget consistent with medium-term needs, let fiscal stabilizers operate, and clarify the direction of other policies.

Partial indexation will mitigate the impact of the sharp rise in inflation on purchasing power, but require wage moderation to preserve competitiveness. The recent spike in energy and food prices and the increase in distribution margins in the energy sector are likely to push average inflation in 2008 to 2.9 percent. Inflation is set to recede in the course of the year, but widespread partial indexation will boost wages in the near term. While the proposed increase in targeted income support through the "heating oil fund" is fully justified, any attempt to boost incomes more generally would be counterproductive and raise the specter of past episodes of difficult adjustment in the aftermath of mishandled supply shocks. Wage discipline, of which there is a good recent track record, will again be necessary to prevent an erosion in competitiveness and second-round effects on inflation. At the same time, product market reforms should be advanced to promote competition, and the level of distribution margins in the energy sector reviewed.

II. Fiscal Policy: Returning to More Ambitious Consolidation and Improving Fiscal Frameworks and Federalism Arrangements

Resuming fiscal consolidation is an urgent priority to address the projected rise in aging-related costs. There is broad public support for a significant pre-funding of the rise in aging-related spending, reflecting concerns about intergenerational fairness and the need to avoid activity-discouraging tax increases or drastic spending cuts in the future. Nonetheless, actual fiscal consolidation has slipped below the path recommended by the High Finance Council (HFC), in part owing to the hiatus in policy making since April 2007. Future surpluses will need to exceed this path to make up for this slippage and catch up with the required reduction in public debt. To facilitate fiscal consolidation, it will be important to coordinate fiscal adjustment with labor and product market reforms (Section III) to set in motion a virtuous circle of fiscal savings, higher employment, higher output and higher revenues.

The authorities' intention to resume structural adjustment in 2008 is welcome. The 2007 budget is likely to post a small deficit instead of the planned surplus. In addition, during the first quarter of 2008, only a provisional budget has been in place. Hence, reaching a surplus of 0.5 percent of GDP already this year, as envisaged under the HFC-recommended scenario, appears to be unrealistic. However, to restore the credibility of the authorities' commitment to fiscal consolidation, ambitious adjustment is necessary. Targeting a structural improvement of ½ percent of GDP in 2008 would seem to strike the right balance with feasibility. It is consistent with the prescription of the stability and growth pact for countries that have not yet reached their medium-term objectives, and would bolster confidence in economic policies, especially important now that other sources of uncertainty cloud the outlook. On the basis of the authorities' macroeconomic assumptions, this approach would imply targeting a nominal budget surplus of nearly 0.2 percent of GDP in 2008, slightly more ambitious than the commonly acknowledged need to at least balance the budget.

Delivering the envisaged structural adjustment will require a concerted effort at all levels of government. Obviously, without compensation elsewhere within the tighter budget envelope, there is no room for new spending initiatives or tax cuts—whose impact on the budget should not be underestimated. But the high tax pressure, especially on labor, also rules out further increases in the overall tax burden. Hence, while specific proposals remain to be worked out, the adjustment will need to focus on expenditure restraint, for which the following will be essential:

• Any savings from a declining interest bill will have to be set aside.

• Entity II (regions and communities) will need to contribute more than envisaged under the internal stability pact arrangements. Sustaining its good performance of 2007 should be feasible, yielding a surplus of at least 0.3 percent of GDP in 2008. Aiming for such an objective is justified because commitments to future spending have increased under public-private partnerships, and the resolution of vertical imbalances in the fiscal federalism arrangements will require a devolution of competencies and associated spending to the regions without a proportional transfer of revenues.

• The social security surplus should be maintained at its current level. The rise in health care spending can be kept in line with trend-GDP growth without compromising the high quality of the health care system.

• Similarly, the envisaged rapid pace of spending growth on priority items in the federal budget will have to be slowed from existing plans, and other discretionary spending curbed, e.g., by streamlining functions across levels of government, deriving efficiency gains from upcoming retirements from the civil service, outsourcing of activities, and cutting subsidies.

• In addition, subsidies for key items rose by ½ percentage point of GDP over the past five years. Partly reversing this process (e.g., by lowering the subsidies for service vouchers) will help fiscal adjustment and raise efficiency and fairness. Moreover, tax exemptions can usefully be tightened.

Refocusing the fiscal framework on a multi-year primary structural surplus objective will be key to achieving consolidation objectives. As intended by the authorities, the measures adopted in the 2008 budget together with upcoming reforms to fiscal federalism arrangements should set in motion sufficient adjustment to deliver the HFC-recommended surplus of 1.1 percent of GDP by 2011, consistent with a primary structural surplus of 4½ percent of GDP. Interest savings from favorable debt dynamics will then bring about further increases in nominal surpluses. The authorities' focus on using structural measures to deliver the required consolidation while avoiding recourse to one-off measures is welcome. Such measures often constitute non-transparent claims on future resources, thereby thwarting adjustment efforts. For the same reason, public-private partnerships should not be used to circumvent fiscal adjustment needs. Risks and future spending obligations related to such arrangements should be reported in a transparent way.

The need to revise fiscal federalism arrangements to address fiscal imbalances among different levels of government is now well recognized. Resolving vertical imbalances will require shifting more of the burden of fiscal consolidation from federal to regional entities. The latter will need to become fully accountable for any decisions that impact the social security system. In addition, strengthening the accountability of municipalities for their budgetary decisions is also desirable. Horizontal imbalances—resulting from regional income and growth differentials and the distribution of revenues on the basis of the personal income tax revenues—raise solidarity, equity, and incentive issues. A broad consensus will have to guide their resolution. It will be essential that any new agreements be neutral from a consolidated budget perspective, provide incentives for regions to work toward narrowing income differences, and are fully transparent about the intergovernmental solidarity mechanisms. Further devolution of competencies should be accompanied by strengthened accountability and stronger coordination among federal and sub-federal entities of both budgetary and other economic policies. For this purpose, fiscal institutions, such as the High Finance Council and the internal stability pact, may need to be strengthened.
III. Structural Reforms: Boosting Employment and Productivity

As recent progress has demonstrated, pressing ahead with structural reforms is key to preserving high living standards and achieving fiscal consolidation objectives. With neighboring countries taking substantive measures to improve the flexibility of their labor and product markets, it will be important for Belgium not to incur significant delays in structural reforms. Furthermore, the opportunity to exploit synergies between fiscal adjustment and such reforms, particularly in the labor market, should not be missed.

To raise participation throughout the country and address high unemployment in some areas, further comprehensive labor market reforms are indispensable. The spotlight on activation policies has been appropriate, but better tailoring of labor market policies to specific regional needs and coordination across regions and sub-regions would raise their effectiveness. The recent good pace of job creation can be sustained through continued wage moderation combined with broader reforms of the tax-benefit system, education, training, and retirement regimes. Specifically, the focus should be on:

• Raising investment in human capital. The enthusiastic pursuit of ongoing initiatives with respect to R&D, the further strengthening of programs for on-the-job and life-long training, and an increase in the efficiency of secondary and higher education are likely to pay off handsomely in terms of the economy's ability to adopt new technologies, attract foreign investment, and maintain comparatively high living standards.

• Removing inactivity traps and keeping older workers in the labor force. To achieve the first, a comprehensive review of the tax-benefit system would be useful. A balanced reform could consist of the phasing out of unemployment benefits—virtually all other industrialized countries have strict time limits and phased benefits—in exchange for an increase in payouts during the first few months of unemployment, and the inclusion of all out-of-work benefits and allowances in taxable income, in exchange for a gradual reduction of these benefits when jobs are taken up. Alternatively, a higher earned income tax credit could be considered. Such an approach would reap the synergies between fiscal adjustment and labor market polices. To help raise employment rates of older workers, the planned extension of activation policies to these workers is welcome, but it will need to be complemented by a complete phasing out of early retirement regimes.

• Sustaining wage moderation and increasing wage flexibility. While the central wage-bargaining framework is likely to continue to maintain competitiveness, shifting its focus from job preservation to job creation would improve labor market outcomes. To take better account of productivity differentials between regions, sectors, and enterprises, and foster a dynamic reallocation of workers to new activities, the practice of "all-in" wage agreements should be extended and larger margins for wage differentiation allowed.

More competition in product markets will boost productivity. Continuing the reduction in the administrative burden on businesses and households will raise efficiency. With respect to competition, the retail and energy sectors require close scrutiny.
IV. Financial Sector: Addressing Turbulence and Preserving Stability

The impact on the financial sector of the ongoing financial turbulence appears manageable. The banking system's strong capitalization, relatively low reliance on wholesale funding, and moderate exposure to sub-prime risk have contributed to a relative resilience to the liquidity shock. Consequently, participation in ECB liquidity operations does not seem to have changed noticeably from pre-crisis levels, and the latest available survey so far shows that banks do not have the intention to tighten lending conditions. While the adverse impact of the turbulence on profitability and balance sheets of financial institutions is likely to be manageable, recent volatility in equity prices indicates continuing market concerns about asset valuations and their implications for banks' earnings and capital. Early and clear disclosure of exposure by financial institutions would help ease such concerns.

Recent and ongoing improvements in prudential supervision have contributed to the resilience of financial system. In line with the 2005 FSAP recommendations, the supervisory framework has been strengthened. Synergies within the CBFA and between the CBFA and the NBB have been further developed. Regular stress tests, covering liquidity as well, have helped promote a systematic dialogue between supervisory authorities and market participants, while detailed procedures for financial crisis management have been established. Prudential supervision of the insurance sector has been upgraded and regulation of the pension funds sector reinforced. These improvements facilitated the handling of the recent financial turmoil.

The ongoing turbulence and changes in the financial landscape require the dedicated attention of the supervisory agency and the central bank. In particular, fostering better disclosure of risk and valuation assumptions and methodologies would help lessen financial turbulence. In line with the authorities' intentions, supervisory capacity and the regulatory response will need to be continuously upgraded to keep pace with market developments, evolving financial instruments, and the complexity of bancassurance conglomerates. With the cross-border dimension of the financial system continuing to gain considerable importance, deeper coordination with foreign authorities will be crucial.