Public Information Notice No. 00/41

Public Information Notice: IMF Concludes Article IV Consultation with the Kingdom of the Netherlands--Netherlands

June 16, 2000

On June 12, 2000, the Executive Board concluded the Article IV consultation with Kingdom of the Netherlands - Netherlands.¹

Background

The Netherlands has enjoyed strong growth and employment performance since the middle of the 1990s, based on sustained fiscal consolidation, ongoing structural reforms, notably in labor markets, and wage moderation. As a result of this policy effort, labor-force participation has risen to the euro-area average and the unemployment rate has fallen to very low levels. More recently, the Dutch economy has moved somewhat out of step with its main euro-area trading partners, and is now in a significantly more cyclically advanced position.

Economic activity remained strong in 1999, with real GDP rising by 3.6 percent, well above the Euro-area average and registration-based unemployment falling to below 3 percent by the end of the year. Despite labor-market tightness, unit labor costs have risen only modestly and consumer price inflation has been moderate. Although competitiveness has deteriorated somewhat against the euro-area since 1998, overall competitiveness against all trading partners has continued to improve. Monetary conditions remained quite supportive from the point of view of the Netherlands in 1999 and into 2000, while the structural fiscal balance improved by more than ¾ of 1 percent of GDP in 1999, due to the preservation of growth-related windfalls, thus withdrawing demand.

The short-term outlook for the Dutch economy is very strong. Real GDP growth is projected to rise to 3¾ percent this year, and then fall off slightly to 3½ percent in 2001. Fuelled by the pick-up in economic activity in European trading partners, the contribution to growth from external demand should be strong, and the current account surplus is likely to strengthen in the near term. Higher interest rates are expected to take some of the steam out of housing markets this year and next, thereby attenuating the wealth effects that have boosted consumption in recent years. On the other hand, the 2001 tax reform will give rise to a significant fiscal impulse. The reform will also increase value-added and environmental taxes, which will raise the price level significantly. Although this effect will be partly offset by lower energy prices, the outlook is for a temporary increase in headline inflation to 3½ percent in 2001. Underlying inflation is set to rise marginally, owing to higher wage increases reflecting the tight labor market.

Structural reforms, notably in labor markets, have been key to the recent strong performance of the economy, though sickness and disability schemes remain large and there is room to raise participation and employment rates further. The 2001 tax reform will reduce the poverty trap somewhat, and the planned reforms to the administration of social benefits should increase the focus on improving employability. The Netherlands is ahead of EU requirements for product market reform, and the government is expanding its program of deregulation. The banking system has well capitalized institutions and changes to the supervisory structure have helped strengthen consumer protection and supervision of conglomerates.

Executive Board Assessment

Executive Directors commended the authorities for the sustained implementation of sound macroeconomic and structural policies, which has raised potential output, kept inflation low, promoted strong employment growth, and reduced the unemployment rate to one of the lowest among industrialized countries. Much of the credit for the economy's extraordinary performance goes to the credibility-enhancing effects of the fiscal consolidation that has been carried out in a rules-based medium-term framework and the implementation of structural reforms, notably in the labor market.

Directors observed that the economy is now several years into a strong cyclical upswing, benefiting from the pickup of activity in the rest of Europe and monetary conditions that remain relatively easy from the perspective of the Dutch economy. With labor markets already very tight and the prospect of above-trend growth continuing, Directors considered that the economy has become vulnerable to overheating risks, although several noted that there are still no decisive signs of inflationary tensions. Directors agreed that recent and prospective interest rate increases are likely to moderate house price increases, thereby tempering private consumption. A gradual loss of competitiveness, from an initially strong position, would also tend to moderate demand growth to more sustainable rates. Some Directors also observed that demand growth would likely be increasingly satisfied by imports, which would be a desirable adjustment in view of the large current account surplus. Nevertheless, further upward demand pressures could lead to an acceleration of wage, asset, and domestic price inflation as well as an increased likelihood of a disruptive downturn. A significant correction in asset prices might accompany, and exacerbate, such a downturn.

In this context, Directors underscored the need for prudent fiscal policy and welcomed the structural improvement in the budget balance in 1999. Most Directors felt that this improvement should be preserved in 2000. To do so, it would be essential to devote all windfalls on the revenue and expenditure sides of the budget to the fiscal balance. Most Directors further cautioned that the proposed increase in expenditure to exhaust the room under the expenditure ceiling would intensify already strong demand pressures.

Directors noted that the authorities' conduct of fiscal policy on the basis of a rules-based medium-term framework has been instrumental in promoting fiscal consolidation and reducing the tax burden. They agreed that the 2001 tax reform—which has been an integral part of the current fiscal framework since its inception—should proceed as planned. Directors recognized the cyclical risks posed by the associated tax cuts, and several noted that it would be important not to add to the fiscal impulse it implied. Overall, however, they considered that the tax reform would have positive benefits.

In line with cyclical requirements, Directors observed that it would be desirable to achieve structural fiscal balance in 2002. They also encouraged the authorities to continue their medium-term approach to fiscal policy beyond 2002 and, in this context, to permit full operation of automatic fiscal stabilizers at least on the revenue side, and to consider explicitly a medium-term path for the structural balance.

Directors strongly supported the ongoing efforts to address remaining labor market weaknesses, in particular to raise participation rates and reduce the large number of disability and welfare recipients. They welcomed the reduction in the labor tax wedge, the introduction of a workers' tax credit (both part of the 2001 tax reforms), the promotion of actuarially fair early retirement schemes, and increased reliance on incentives for firms to limit claims on the sickness program. To complement this approach, Directors advocated measures that would scale back income-related benefit programs and lower replacement rates, recognizing that it would take time to build consensus to reduce social benefits. They also underscored that, to reap the benefits from the promising reorganization of the social security system, it would be essential to take a comprehensive view of the transition from welfare to work and ensure that proper financial incentives are put in place.

Recognizing that there has already been significant progress in some areas, Directors encouraged the authorities to expand product market reforms further. They welcomed the establishment of an independent body to assess publicly the administrative burden of new legislation, while urging the authorities to ensure steady progress in reducing the burden itself. Directors also supported the initiatives to raise the public profile of the umbrella project for the promotion of market forces, deregulation, and improvement in quality of legislation, and to push for stricter timetables for implementing the recommendations in these areas.

Directors observed that the country's sound financial system has underpinned economic prosperity. In light of the rapidly evolving structure of financial markets, they welcomed the establishment last year of the Council of Financial Supervisors, noting that it has been instrumental in improving the supervision of conglomerates and fostering consumer protection. Directors also urged the authorities to maintain a sharp focus on mortgage market risks.

Directors commended the authorities for their continued support for trade liberalization on a multilateral basis. They also welcomed the substantial level and high quality of official development assistance, which has remained above the United Nations target.