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Norway -- 2005 Article IV Consultation, Preliminary Conclusions of the IMF Mission
March 15, 2005
The Norwegian economy rebounded strongly in 2004, following a relatively short slowdown. Very supportive monetary conditions, a reversal of the exchange rate appreciation that took place in 2002, a large increase in disposable income (attributable in part to strong terms of trade gains), modest fiscal stimulus, and the substantial rise in oil prices all contributed to robust growth. Employment also appears to be picking up, after lagging in the earlier stages of the recovery. Core inflation has been well below the 2.5 percent inflation target, reflecting the emergence of excess capacity during the slowdown, correspondingly moderate wage pressures, and structural factors, notably falling prices for some imported consumer goods and intensified domestic competition. The outlook for this year and next remains bright, though the pace of growth is likely to slow somewhat. Sharp declines in world growth or oil prices pose potential downside risks.
Beginning the gradual withdrawal of monetary stimulus is likely to be warranted in the course of this year. Some accompanying exchange rate appreciation may also occur as part of the monetary transmission process. While the supportive monetary stance of the past year has been appropriate in view of the very low inflation rate, indicators increasingly suggest that inflationary pressures are beginning to surface. Robust economic growth is rapidly eliminating excess capacity and, although precise judgment on this point is difficult, there are signs that the structural factors are waning. The outlook for the interim wage negotiations this year is benign, but labor markets will most likely be tighter in 2006 when the more important two-year negotiations are scheduled to take place. Moreover, low interest rates are contributing to strong credit growth. Mortgage lending, fuelled by house price increases, has been particularly important, but lending to businesses has also begun to pick up, partly reflecting the oil boom. While risks to financial sector stability are contained for now (see the evaluation of the financial sector below), they will intensify if rapid credit expansion continues.
The inflation targeting framework has been instrumental in stabilizing the economy and appears to have gained considerable credibility. According to survey evidence, medium-term inflationary expectations remain firmly anchored at 2.5 percent. Recent measures have further improved transparency. The decision to publish the monetary policy strategy document with the inflation report—that is, at the beginning rather than the end of the strategy period—is welcome. Also, the statement following policy meetings now provides additional detail regarding the decision-making process, further enhancing guidance to markets. The authorities may wish to consider taking another step in this direction by publishing minutes of the policy meetings, as some other central banks do. However, the perception remains in some quarters that, after the events of 2002, Norges Bank's room for maneuver has been constrained by an overriding concern to avoid an exchange rate appreciation. The authorities should therefore continue their efforts to communicate the framework to markets and the social partners, in particular by emphasizing that the exchange rate is not an independent monetary policy objective.
Norway's fiscal policy has been prudent overall, but the recurring deviations from the rule limiting the central government structural non-oil deficit to 4 percent of the government petroleum fund (GPF) merit concern. The 2001 fiscal guidelines, if adhered to, allow sustainable use of oil revenues while preserving realized oil wealth for future generations. Deficits have been well contained under the guidelines, although political pressures to spend oil money have been strong and the 4-percent fiscal rule has never been met. In 2002-03, the overruns reflected extraordinary events and were to that extent consistent with the broader guidelines. However, in 2004 and in the 2005 budget this was no longer true: economic growth was strong and the GPF was growing rapidly as equity markets recovered and oil prices rose. The 2005 budget essentially used the positive surprise to the GPF to expand the non-oil structural deficit, rather than taking the opportunity to return to the 4-percent rule sooner.
Deviations from the rule, if they continue, may undermine the credibility of the guidelines, which may in turn put unwanted upward pressure on the krone. The authorities should therefore demonstrate resolve by strictly controlling spending growth in order to narrow the structural deficit and return to the rule sooner than now envisaged. In this regard, the 2006 budget will be critical. Buoyant economic conditions provide an opportunity to rein in the deficit and recover some of the ground lost in 2005. Policy during the course of 2005 will also be important. Any further slippage should be avoided, and lower-than-anticipated spending on sickness benefits should be used for deficit reduction rather than other spending.
The current fiscal guidelines should also be buttressed by a medium-term fiscal plan, conceived as an integral part of the budgetary process. In Norway, such a plan would be particularly useful to map out a specific and credible path back to the 4-percent rule. Many other countries have successfully used variants of such frameworks to guide the annual budgetary process toward medium-term objectives. The key components of such plans include spending ceilings and deficit objectives, as well as concrete measures to achieve them.
The proposed tax reforms are welcome. The shift from the split to the shareholder model should stem the growing problem of tax arbitrage by artificial shifting of labor income to capital income. The reduction in the tax burden on labor should help to boost employment. However, it is worth emphasizing that revenue losses need to be made up on the expenditure side. With the elimination of the tax on imputed rent, housing has become even more favored than before, increasing the incentives for misallocation of saving. The authorities should therefore consider reducing mortgage interest deductibility or raising property taxes in the context of a future tax reform.
The key long-term fiscal issue facing Norway, as in many other countries, is the rise in pension spending associated with population aging. This process will span a number of decades, but early action will forestall the need for harsher measures later; moreover, Norway's oil wealth will fall far short of covering all future pension obligations. Against this backdrop, adoption of the government's pension reform package is crucial, although further measures will be needed in the future to fully solve the long-term financing problem.
The proposed reform package would cut long-term outlays, while the provisions for life-expectancy adjustment and flexible retirement will enhance work incentives. To ensure these latter measures are effective, however, the replacement rates of disability program (which is becoming a de facto early retirement scheme) need to be realigned with the new pension replacement rates for those retiring early. Also, the substantial government subsidy to early retirement programs should be phased out. Finally, changing the GPF into an explicit pension fund would help to insulate it from political spending pressures, but it will be crucial for continued macroeconomic stability to retain the policy of investing the funds abroad.
The Norwegian labor market performs very well, but the persistent expansion of the sickness and disability programs has raised growing concerns that the situation may deteriorate. These programs have gradually, but perceptibly, cut into the labor force, and they place an increasing strain on the public finances. Last year's fall in hours lost to sickness, reflecting stricter medical exams and other adjustments, while encouraging, was small relative to past increases in the program, and might not be sustained. These considerations point to the need to consider further tightening of administrative controls and to review the very high replacement rates, especially in the sickness program.
Product markets also appear to perform well overall, and the increased competition in recent years is especially encouraging. Competitive forces should continue to be fostered, including through further deregulation and vigorous action by the Competition Authority. In this regard, the overhaul of the competition law, which largely aligns it with relevant EU law, is welcome. The state retains an important ownership position in a number of commercial firms. Significant and welcome institutional changes have been implemented to help to ensure that state-owned enterprises operate on a purely commercial basis and on an equal footing with privately owned businesses. Nevertheless, the existence of significant state ownership may lead to the perception that the playing field is not level and, in any case, precludes takeover threats, an important mechanism of corporate governance. Further privatization should therefore be high on the reform agenda.
Norway's financial system is well managed, well supervised, and currently sound overall. The recent Financial Sector Assessment Program (FSAP) found that Norwegian banks are currently well positioned to deal with potential risk factors, with sound capital positions, strengthened risk management practices and improved profitability. In addition, following losses in previous years, the insurance and pensions sectors have reinforced their financial positions, assisted by strengthening global equity markets. However, life insurance companies continue to face a challenging environment and remain susceptible to adverse market movements.
Rising household debt will become, over time, an increasingly important risk factor for the financial system. While overall debt servicing costs relative to incomes are not at present exceptionally high by historical standards, the growth in borrowing by vulnerable groups, such as the young, is particularly marked. Given prospective increases in debt levels, a sharp rise in interest rates, especially if coupled with significant declines in house prices, or in household incomes and employment, could adversely affect the banking sector. The main mechanism may be heightened commercial credit risk, because business conditions could deteriorate if household demand is squeezed by higher mortgage payments. The authorities are monitoring developments very closely—their financial stability analyses and publications are exemplary—and will of course need to continue doing so.
The FSAP confirmed that Norway's main payments system and its supervisory arrangements compare very favorably with international standards. Nevertheless, further strengthening of some risk management arrangements would be desirable in the securities settlement system, as would measures to further reduce risks in the retail payments system. Continuing coordination with other authorities in the region will be needed to address issues raised by cross-border financial institutions, and further formalization of a few aspects of supervisory arrangements would also be useful. The latter includes supervisory requirements and standards for payments and settlement systems; and also some of the powers of the Financial Services Authority. Finally, over time, it would be useful to review some other institutional arrangements, to ensure they continue to make the best contribution to a sound and competitive financial system. These include the future of the netting arrangement within the payments system; the deposit guarantee system for banks; and measures to minimize the potential disadvantages of state ownership of banks.
Norway's trade regime is generally quite liberal, as barriers to most goods have been eliminated, in some cases (such as textiles) well before international agreements required it. The outstanding exception is agriculture, which remains highly protected. Although the resulting trade distortions are minor in a global context, the significant cost to Norwegian consumers, in terms of higher prices and limits on choice, argues for a reduction in these trade barriers. Norway's commitment to official development aid, which exceeds the UN target of 0.7 percent of GNI, is commendable.
Oslo, March 15, 2005
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